Business Loans

Understanding Factor Rates

There are instances when small business owners find themselves in a pinch and need an infusion of cash quickly. It’s during these times that business owners may seek out financing from a merchant cash advance (MCA) or short-term business loan and encounter factor rates for the first time.

What is a factor rate?

Annual percentage rate (APR) is a familiar term for the cost of borrowing. Factor rates, on the other hand, are lesser known and specific to business funding. Also known as buy rates, factor rates are expressed as a decimal figure typically between 1.1 and 1.5. The rate depends on a small business’s industry, length of time in business, stability of sales and its average monthly credit card sales, according to The Business Backer.

MCAs commonly use factor rates over APRs. It’s important to note that MCAs aren’t loans; rather they are an advance of money in exchange for a percentage of your future credit or debit card sales. An MCA company provides funds that you pay back daily based on the sales you make. Since your repayment is based on a percentage of your sales, the amount you pay back increases and decreases depending on your daily sales.

How to calculate a factor rate

Say you get a $10,000 cash advance at a 1.25 factor rate. To determine how much you will ultimately pay back to the MCA provider, multiply the cash advance amount by the factor rate.

Advance amount x factor rate = Total payback of advance

In this instance, the calculation would be:

$10,000 x 1.25 = $12,500

You would pay back $12,500 total to the MCA provider for borrowing $10,000. That means the cost of the advance is $2,500.

That may seem steep for the principal amount, but MCAs are among the most expensive funding products available. They’re a big risk to the MCA provider because, unlike a loan, there is no personal guarantee and no obligation to repay the advance amount. That’s one of the main reasons why MCAs tend to cost so much more.

Factor rates vs. interest rates

It’s important to understand factor rates, interest rates and APRs to adequately compare funding options for your small business. The interest rate is the percent of the principal charged by the lender for borrowing. Here’s how a factor rate and interest rate differ:

Factor rate Interest rate
Expressed as a decimal Typically expressed as an annualized percentage
Applied to original amount Applied to remaining balance
Applied to MCAs Applied to loans and credit cards

 

Convert factor rate into annualized interest rate

To compare an interest rate on a loan to a factor rate on a cash advance, follow these steps using the above example of a $10,000 cash advance at a 1.25 factor rate with an expected repayment period of 180 days or six months.

Step 1: Calculate the total cost of the advance

Advance amount x factor rate = Total payback of advance

$10,000 x 1.25 = $12,500

Step 2: Calculate the cost of the advance

Total payback of advance – advance amount = Cost of advance

$12,500 – $10,000 = $2,500

Step 3: Calculate the percentage cost

Cost of advance / advance amount = Percentage cost

$2,500 / $10,000 = 0.25

Step 4: Calculate the annualized interest rate (this is a two-part step)

Percentage cost x 365 (days in a year) = X

0.25 x 365 = 91.25

X / Expected repayment period (in days) = Annualized interest rate

91.25 / 180 = 0.5069 or 50.69%

This means you’re essentially paying a 50.69% annualized interest rate on the $10,000 cash advance. A $10,000 term loan typically would come with a much lower interest rate, but would be harder to qualify for.

It’s much harder to convert a factor rate into an APR, which is the best indicator of the true cost of a loan or advance. There are some online calculators that can help with this. However, converting a factor rate into an annualized interest rate is a simple way to accurately weigh the cost of a merchant cash advance.

Do usury laws regulate MCAs?

You may be wondering if usury laws come into effect here. In most states, there are usury laws that regulate loan transactions. These laws place a cap on the rates lenders can apply to funds to borrowers. However, MCAs are not loans. Usury laws don’t apply to merchant cash advances, which is why some lenders offer cash advances to get around these laws.

Repayments on merchant cash advances are conditional, making them exempt from usury laws. Unlike with small business loans, where repayment is required no matter the circumstance, payments on cash advances are based on the business’s ability to generate future sales. You’re no longer required to repay the advance if your business fails.

What determines your factor rate?

While it’s typically easier to qualify for a merchant cash advance, an MCA provider will still consider several factors before advancing the funds to your small business.

  • Your business’s industry: Some industries carry different levels of risk. For example, cyclical industries experience periods of high and low sales depending on the season or demand.
  • Length of time in business: Most MCA lenders require small businesses to be in operation for at least 12 months, although some may accept less. Traditional lenders have stricter requirements, requiring two years or more in business.
  • Business sales and growth: This allows the MCA provider to perform a financial assessment on your ability to repay the advance. MCAs are typically repaid with their future credit or debit card sales or other receivables. You should provide at least three months’ bank statements.
  • Average monthly credit card sales: This also shows how likely the business can repay the advance amount. MCAs are based on future revenues, which also include a percentage of your business’s daily credit or debit card sales. Showing consistent sales over the last three months indicates your ability to meet the terms of the cash advance.
  • Business credit history: Your business credit score is used as a way to measure the creditworthiness of your business. MCA providers may also consider your personal credit history as an indication of your ability to repay the advance based on the agreed upon terms.

Bottom line

A factor rate, also known as a buy rate, isn’t the same as an interest rate or APR. Calculating a factor rate is easier than determining an interest rate or APR, but is generally associated with higher-risk lending products such as merchant cash advances and short-term loans. There are a lot of variables that determine a factor rate, so it’s important to ensure you understand how its calculated before taking out an MCA.

 

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