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What Is a Factor Rate and How Do You Calculate It?
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Factor rates are used to calculate the cost of certain business financing products, such as merchant cash advances. Factor rates are written as decimal figures rather than percentages like interest rates. Using factor rates to figure out interest on business financing may seem tricky at first, but it’s a simple calculation.
What is a factor rate?
Factor rates are specific to business funding and are less common than annual percentage rates (APRs), which incorporate the interest rate and fees. Factor rates, sometimes called buy rates, are typically between 1.1 and 1.5. The rate depends on your:
- Small business’s industry
- Length of time in business
- Sales stability
- Average monthly credit card sales
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.
Merchant cash advances, or 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. MCA amounts typically range from $5,000 to $500,000, though you could receive as much as $1 million.
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
To determine how much you would pay for financing, you would multiply your financing amount by the factor rate. The total would be the amount that you’d pay back to the lender.
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:
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’s 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 rate vs. interest rate vs. APR
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. The APR reflects the total cost of borrowing as a percentage, including the interest rate and additional fees.
Here’s how a factor rate and interest rate differ:
|Factor rate vs. interest rate|
|Factor rate||Interest rate|
In most states, usury laws regulate loan transactions. 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 loans, which is why some lenders offer cash advances to get around these laws and charge higher rates.
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.
How to convert a factor rate into an annualized interest rate
To compare an interest rate to a factor rate, you need to do a conversion. Follow these steps using the previous example of a $10,000 merchant cash advance at a 1.25 factor rate with an expected repayment period of 180 days, or six months.
Step 1: Calculate the total payback account
Step 2: Calculate the cost of the advance
Step 3: Calculate the percentage cost
Step 4: Calculate the annualized interest rate (2-part step)
What 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 qualifying would be harder.
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.
Meantime, converting a factor rate into an annualized interest rate is a simple way to accurately weigh the cost of a merchant cash advance.
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 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.
FAQs on factor rates
What is a factor rate?
A factor rate is a tool expressing interest rates on business financing in decimal form. Certain short-term funding, like merchant cash advances or short-term loans, are more likely than others to illustrate the cost of funding with factor rates.
How do you calculate a factor rate?
You would multiply your factor rate by your funding amount to determine the total cost of financing. The calculation would show the total repayment amount.
When would a factor rate be preferable over an APR or interest rate?
It may be easier to calculate the cost of financing using a factor rate compared with an APR or interest rate. Multiplying your factor rate and your funding amount would show the total that you’d repay. Although, factor rates often convert to high APRs, which could be unsettling if you’re used to seeing APRs when borrowing money.
What determines interest rates?
Lenders consider several business details when determining how much a borrower will pay in interest. Revenue, time in business, credit history, sales, industry and overall business growth are among the factors that impact your interest rate.