What Is a Factor Rate and How Do You Calculate It?
Factor rates are decimal numbers used to calculate the cost of certain business financing products, such as merchant cash advances. Using factor rates to figure out interest on business financing may seem tricky at first, but it’s a simple calculation.
- Like an interest rate, a factor rate is a metric for determining the cost of borrowing small business funding.
- Multiplying the factor rate by the loan amount gives you the total amount you’ll need to pay back
- The factor rate you’re given can depend on a variety of factors, including your industry, time in business, credit history and total sales.
- You can convert a factor rate into an interest rate to compare loans.
What is a factor rate?
Like an interest rate, a factor rate is a number that tells you how much it will cost to borrow a loan or cash advance. Unlike an interest rate, a factor rate is expressed as a decimal (instead of a percentage) and is not annualized. That means that it tells you the total amount you’ll pay for the loan, rather than the amount you’ll pay each year.
Factor rates are specific to small business funding and are less common than annual percentage rates (APRs), which incorporate an interest rate and fees. Factor rates, sometimes called buy rates, typically range between 1.1 and 1.5.
Factor rates are generally associated with high-risk lending products, such as merchant cash advances or short-term business loans from alternative, nonbank business lenders. These funding options typically have fast repayment terms and high rates on relatively small amounts, but lenient eligibility requirements.
How are factor rates commonly used?
Merchant cash advances (MCAs), most commonly use factor rates over APRs. It’s important to note that MCAs aren’t loans. Rather, they’re an advance of money in exchange for a percentage of your future credit or debit card sales.
Merchant cash advances often have high fees, and because they aren’t required to follow the Truth in Lending Act, there’s often not enough transparency around what you’ll pay. Calculating the total cost of your loan can help you understand whether it’s affordable for your business.
In most states, loan transactions are regulated by something called usury laws. These laws place a cap on the rates that lenders can charge. However, the regulation doesn’t apply to merchant cash advances because they aren’t technically considered loans, which is why some lenders offer cash advances to get around these laws and charge higher rates.
Before taking out an MCA, make sure you read the full business loan agreement and understand all charges and fees associated with the loan.
Factor rate vs. interest rate vs. APR
Although factor rates, interest rates and annual percentage rates (APR) are all metrics used to show the total cost of borrowing a loan or advance, they all work a bit differently.
- Factor rates are multiplied by your financing amount to show the total cost of funding.
- An interest rate is the percentage of the principal charged by the lender for borrowing.
- A flat interest rate shows the total percentage of the principal charged by the lender.
- An annualized interest rate shows the percentage of the principal charged by the lender, calculated yearly.
- The APR reflects the total cost of borrowing as a percentage you’ll pay each year, including the interest rate and additional fees.
Here’s a closer look at how a factor rate and interest rate differ:
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How to calculate a factor rate
To determine how much you’ll pay for a loan or cash advance, multiply the amount you’re borrowing by the factor rate. The total is the amount that you’ll pay back to the lender.
Advance amount x factor rate = total payback amount
Say you get a $10,000 MCA with a 1.25 factor rate. To figure out how much you’ll pay back to the MCA provider, multiply the cash advance amount by the factor rate.
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 total cost of the advance is $2,500.
How to convert a factor rate into a flat interest rate
Some loans, especially short-term loans and advances, will express interest as a flat interest rate rather than an annualized one. A flat interest rate means that the same amount of interest will be charged, regardless of how long it takes to repay the loan.
In this case, the calculation is fairly simple:
(Factor rate – 1) x 100 = flat interest rate
If you were given that same $10,000 MCA with a 1.25 factor rate, the equation would look like this:
(1.25 – 1) x 100 = flat interest rate
(0.25) x 100 = flat interest rate
25% = flat interest rate
This means you’ll pay back 25% more than you borrowed.
How to convert a factor rate into an annualized interest rate
You can use a calculator to convert a factor rate to an annualized interest rate in under a minute. To calculate a factor rate, use this equation:
(Factor rate – 1 / months in MCA term) x 12 x 100 = annualized interest rate
For example, if you have a factor rate of 1.25 for an 18-month loan term, you can get the annualized interest rate by dividing 0.25 by 18, and then multiplying that answer by 12. Punch it into your calculator, and you’ll get 0.1667. Multiply it by 100 to convert the decimal to a percentage, and it’s a 16.67% interest rate.
If your loan term is in days instead of months, you can just swap the months in a year for days in a year and the equation still works.
(Factor rate – 1 / days in MCA term) x 365 x 100 = annualized interest rate
Next, you divide that number by the months in your term — this gives you the interest you’re paying each month.
Then, multiplying it by the 12 months in a year gives you the interest you’d pay if that was charged each month for a year, aka the annualized interest rate.
It works the same way for days — dividing the amount you’re paying the lender in addition to what you borrowed by the number of days you’re paying it over gives you the amount you’re paying each day. Multiplying it by the 365 days in a year gives you the interest you’re paying annualized.
When you’re dealing with factor rates, the loan term you select can have a drastic impact on your interest rate. To illustrate what we mean, consider the cost of a merchant cash advance with a three-month repayment period versus a one-year repayment period where all other factors are the same.
If you take out a $5,000 MCA at a factor rate of 1.10 and a three-month repayment period, your annualized interest rate would be 40%. In contrast, with a one-year repayment period, the interest rate would only be 10%.
In both cases, you actually pay the same amount of interest, $500, even though the annualized rate is drastically different. This is why it’s crucial to make sure you’re comparing the same type of rates when comparing lenders.
Total payback amount:
Advance amount x factor rate = total payback amount
$5,000 x 1.10 = $5,500
Total cost of borrowing:
Total payback amount – advance amount = cost of borrowing
$5,500 – $5,000 = $500
Percentage cost of the advance:
Cost of advance / advance amount = percentage cost
$500 / $5,000 = 0.10
Now that we have that information, we can calculate the interest rate for each of the two loan terms.
Three-month loan term:
((1.1 factor rate – 1) / 3 months in the loan term) x 12 months in a year x 100 = annualized interest rate
(0.1 / 3) x 12 x 100 = annualized interest rate
0.03333 x 12 x 100 = 40%
One-year loan term:
((1.1 factor rate – 1) / 12 months in the loan term) x 12 months in a year x 100 = annualized interest rate
(0.1 / 12) x 12 x 100 = annualized interest rate
0.00833 x 12 x 100 = 10%
It’s more difficult to convert a factor rate into an APR, which would be the best indicator of the true cost of a loan or advance. Online factor rate calculators could help you convert a factor rate into an APR. Meanwhile, converting a factor rate into an annualized interest rate is a simple way to accurately weigh the cost of a merchant cash advance or loan product.
How lenders determine your factor rate
While it’s typically easy for business owners to qualify for MCAs and other short-term products associated with factor rates, lenders and financing companies would evaluate several aspects of the business before assigning a rate.
- Business’s industry: Some industries carry different levels of risk. For example, cyclical industries, such as hotels or restaurants, experience periods of high and low sales depending on the season or demand.
- Length of time in business: Many MCA providers require small businesses to be in operation for at least six months, though traditional lenders have stricter eligibility requirements, often 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. You should provide at least three months’ worth of bank statements.
- Average monthly credit card sales: This also shows how likely the business can repay debt. MCAs are typically repaid with a percentage of daily credit or debit card sales or other receivables. Showing consistent sales over the last three months can indicate 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.
Before accepting an offer, shop around for financing to get a factor rate and terms that work for your business. Make sure the cost of financing is within your budget and repayment terms aren’t too fast to keep up with.
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