Understanding the Merchant Cash Advance
It’s no secret that most businesses often need debt to drive growth and profitability, and in an increasingly digital world, debt is becoming more accessible. However, the growth in debt accessibility isn’t universally a good thing. Some borrowing methods marketed to small business owners, such as merchant cash advances, have confusing marketing, poor underwriting standards and astronomic interest rates that can trap business owners in unsustainable debt cycles.
Although an MCA looks like a typical loan, the transactions are almost completely unregulated. This means that most small business borrowers are not shown the APR or expected monthly payment before they take out a merchant cash advance. And since cash advance issuers aren’t bound by any laws that limit interest rates on loans (usury laws), issuers can legally charge massive interest rates — in excess of 100% in many cases.
“I think that business owners and the public at large are shocked to find out that these transactions have almost no regulation at the state or federal level,” said Gwendy Brown, vice president of research and policy with Opportunity Fund, a nonprofit small business lending company. “We hear about lenders trying to get around laws, but this is different. There are no protections with cash advances.”
How a merchant cash advance works
Merchant cash advances technically aren’t loans. A merchant cash advance provider would purchase a portion of your receivables — typically credit card transactions — in exchange for a lump sum of funding. Here’s more about how they work:
- A business owner receives a set dollar amount in their bank account.
- In exchange, the business owner agrees to pay the issuer a fixed percentage of future credit card sales until the advance, plus a borrowing fee (interest), is paid off.
- Merchant cash advances are fixed-price loans. That means that a business owner will pay a fixed amount of interest for the upfront cash no matter how quickly they pay off the loan.
- Payments on cash advances are made daily, and fluctuate as sales volume fluctuates. On days where the business owner has lower revenue, the business makes a lower payment, and on days when they have higher revenue, they have a higher payment.
- Whether sales are up or down, the issuer is almost guaranteed to get their cut of the daily sales. “The daily repayments are actually tied in with the credit card processing systems,” explained Brown. “It’s lower risk form of financing [for the lender] because the ‘lender’ gets the money before it even goes to the businesses.”
- A merchant cash advance contract would usually require you to agree to operate the business to the best of your ability and not undermine business performance in order to hinder your payments. You wouldn’t be responsible to repay the advance if the business fails for reasons outside your control.
Should I get a merchant cash advance?
Taking on a merchant cash advance can be risky. Much like payday loans, merchant cash advances have high fees and fast repayment terms. Businesses without other financing options can easily get stuck having to re-up cash advances — it’s common for businesses to take on more than one MCA at a time to try to stay afloat.
But there are some advantages over traditional business loans including flexibility and time to funding. Business owners can apply within minutes and get funded right away. Basing payments on a percent of daily sales means that you would make a lower payment on days when your sales are low. The faster you generate sales, the quicker you pay back the advance. This is also why it’s difficult to tell what you’re paying in overall interest versus traditional loans with an annual percentage rate (APR) and set monthly payment. We’ll talk more about alternatives in a minute.
When a merchant cash advance makes sense
Short-term cash crunch. A merchant cash advance could be a suitable solution for an immediate cash crunch if your business generates substantial sales and you feel comfortable managing payments alongside your daily operating expenses. In other words, an MCA is best for short-term expenses where you could quickly recoup your investment.
Non-operating expenses. To repay your cash advance, you’d need to give up a portion of your daily sales. As long as you have a handle on your operating expenses and can afford to forgo a portion of your receivables, merchant cash advance repayments shouldn’t overly impact your cash flow.
Credit issues. Because the underwriting process for merchant cash advances is typically minimal, you could receive funds in a few hours after being approved. Business owners who aren’t eligible for traditional loans could qualify for a merchant cash advance because of lenient credit requirements.
Alternatives to merchant cash advances
Business owners aren’t always interested in the absolute lowest cost of financing. Sometimes important factors like speed and ease of application are important. However, business owners should understand the financing alternatives that may be available to them.
Working capital loans
Unsecured working capital loans are another product that tend to carry high interest rates and daily payments. Like merchant cash advances, borrowers can apply and receive funding quickly, often in less than two business days. Despite the high speed and high interest, working capital loans tend to be a better choice than cash advances. Several prominent unsecured loan providers are using a SMART Box™ to disclose APR and monthly payments for the loans. A SMART Box is a basic disclosure of all the fees associated with the loan that makes it easy to compare loans from different lenders. The information contained in a SMART Box can help business owners decide whether the loan makes sense or not.
If business owners have time on their side, an SBA microloan offers term loans for less than $50,000 at moderate interest rates (between 6.5% and 9%). Microloans aren’t issued directly by banks. Instead, nonprofit lenders called intermediaries fund the loans. Business owners may be able to work with their local intermediary to refinance an existing cash advance.
Small business credit cards
A creditworthy business owner may be able to access their financing needs through small business credit cards. According to the 2019 Small Business Credit Survey by the Federal Reserve Bank of New York, more than four out of 10 small business owners in need of financing turned to credit cards. Although credit cards carry higher interest rates than most term loans, they offer small businesses multiple benefits. For example, a credit card may help a business build its business credit score, and in many cases interest on credit card purchases doesn’t start accruing until the end of a billing cycle.
Peer-to-peer (P2P) term business loans
P2P lending isn’t just for consumers seeking personal loans. Certain P2P platforms offer business loans at rates that range from as low as 4.99% to 29.99% APR. These loans require monthly payments, but they may be funded almost as quickly as cash advances for qualified business owners.
Where to shop for short-term business loans
One of the most accessible alternatives to a merchant cash advance is an unsecured short-term business loan. Business owners can apply for these loans quickly, and receive funding in just a few days. However, these loans aren’t a panacea for business owners. Some carry high interest rates, and some lenders do not transparently disclose APRs or monthly payments.
Still unsecured short-term business loans tend to be a better choice for many businesses. This is due to the fact that many nontraditional lenders are voluntarily disclosing APRs, fees and monthly payments. The trend toward transparency gives business owners a chance to decide whether the unsecured loan makes sense or not.
To get the best possible rate on an unsecured short-term loan, consider shopping through an online marketplace like LendingTree. LendingTree allows business owners to apply for multiple small business loan offers with a single application.
Key terms to understand before you apply for a merchant cash advance
In the marketing literature, cash advance issuers use words that sound like interest rate but mean something completely different. For example, terms like factor rate, cents on or interest fee can be confused for APR. Business owners who try to calculate the APR based on these specialized terms often miss the mark, and dramatically underestimate the cost.
The lack of standard information means that lenders can use different language to explain the cash advance product. In fact below, we give two examples that could be used to explain the exact same product.
We’ll unpack the jargon here to help business owners understand the industry terminology.
Upfront funds: This refers to the cash you’ll get immediately once a merchant cash advance clears. It is the amount of money you borrow in a merchant cash advance. In our examples, the amount borrowed is $10,000.
Price (also fixed fee, total cost): In the following examples, the merchant pays $11,400 to borrow $10,000. That means the merchant must pay back the initial $10,000 plus the $1,400 loan fee. Whether it takes you three months or six months to pay off the loan, the cost will remain $11,400.
Factor (buy rate, cash on): A factor expresses the total cost of the loan as a factor of the borrowed amount. In the second example, we see the factor rate 1.14. This means that the merchant will pay $11,400 to borrow $10,000.
Remittance rate (also daily card sales, percentage payback): The remittance rate is not your interest rate, even though some borrowers think it is. Business owners pay back their cash advances through a series of variable payments. The exact payment the owner makes each day is based on a percentage of credit card sales for the day. In both examples, we see that the merchant agrees to commit 11% of credit card sales per day to the loan. On a day where the merchant takes in $4,000 via credit cards, she will pay $440 toward the advance. On a day where she takes in $8,000 she’ll pay $880 toward it.
Origination fee: Most of the time, origination fees are calculated into the total price of the loan (explained above). However, an MCA lender could charge an origination fee on top of their factor fee. This drives up the total cost of the loan.
|Example 1: Cash advance product priced based on borrowing cost|
|Credit score needed||500 FICO|
|Time to get cash||24 hours|
|Percent of daily credit card sales||11%|
|Example 2: Cash advance product priced based on factor rate|
What to watch out for
1. High costs over time
Cash advances have a reputation of being high-interest loans. The actual cost of these products can be massively underestimated, even by business owners. Although an MCA looks like a typical loan, the transactions are almost completely unregulated. This means that most small business borrowers are not shown the APR or expected monthly payment before they take out a merchant cash advance. And since cash advance issuers aren’t bound by any laws that limit interest rates on loans (usury laws), issuers can legally charge massive interest rates — in excess of 100% in many cases.
2. Difficult to compare rates
Cash advance issuers often use intentionally confusing pricing language that makes it difficult compare the rates on cash advances to alternative products such as working capital loans, credit cards or lines of credit. Most of the time, business owners taking out cash advances don’t have any visibility to the APR on the loan or the average monthly payment they will make.
3. Hidden fees
The high interest rates and opaque pricing aren’t the only problems with merchant cash advances. In a 2016 working paper, Karen Gordon Mills and Brayden McCarthy of Harvard Business School documented that brokers working in the cash advance and working capital loan space may charge brokerage fees as high as 10% to 20%. These are fees that brokers charge customers for their services on top of the fees charged by lenders. These brokers may not live up to a fiduciary standard, which means they may recommend cash advance or high-interest rate loan products based on the commission they earn from the product.
Research from the Opportunity Fund showed that some cash advance issuers practiced “double-dipping,” which Brown explained is a term meaning the lender charged interest on the same money twice. This happens most frequently when a business owner refinances a cash advance or asks to borrow more money.
5. A debt spiral
The low underwriting standards also mean that some business owners end up “stacking” cash advances. This means they take out more than one at a time to try to cover their current advances. In a 2016 report by Opportunity Fund, over a quarter of all business owners had outstanding loans with more than one alternative lender.