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What You Need To Know About Factor Rates

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The world of borrowing as a small business owner has many options. If you’re looking at a merchant cash advance (MCA) or invoice factoring, you might have seen the term “factor rate” and wondered what it meant. A factor rate is the cost charged on some small business loan products.

This rate represents how much you’ll pay to borrow if you choose to open that loan product. It’s shown as a decimal figure rather than a percentage, and thus can be confusing to small business owners more accustomed to the interest rate charge on loans and credit cards. While this new concept may appear tricky the first time you encounter it, it’s actually pretty simple.

Here’s what you need to know about factor rates and how to calculate them.

What Are Factor Rates?

A factor rate is the cost of a loan if the lender chooses not to charge interest. A lender that charges interest will express the loan’s cost as a percentage – for example, 5.50%. But a lender that charges a factor rate will show it as a number, typically between 1.4 and 1.5. A factor rate is a lump sum you pay to borrow the capital.

What’s the Difference Between a Factor Rate, Interest Rate, and APR?

While factor rates are multiplied by your loan amount to show the total cost of funding, an interest rate is the percentage of the principal the lender charges for borrowing. Annualized percentage rate (APR) shows the total cost of borrowing as a percentage, and includes both the interest rate and any additional fees. In an amortizing loan, you can save money by paying it off early or making extra payments, because this reduces the amount of principal the interest is applied to, but the same isn’t true for a factor rate. 

To further break them down:

Factor Rate
Interest Rate
Shown as a decimal figure
Shown as a percentage
Shown as a percentage
Applies to the original loan balance
Applies to the original loan balance
Applies to the original loan balance, includes fees
Used with MCAs and other higher-risk lending products
Used with loans, credit cards, and multiple other types of financing
Used with loans, credit cards, and multiple other types of financing

If you have any doubts about which of the above your lender is planning to charge for your loan, ask them for clarity. 

What Does the Factor Rate Depend Upon?

The factor rate that a lender decides to charge you depends upon: 

  • How long you’ve been in business – Many MCA providers require that your small business have been operating for at least six months, though some reduce this requirement based on cash flows. Traditional lenders often require two or more years in business to qualify.
  • Your industry and its risk factors – Industries have different risk factors. Those that are subject to seasonality – hotels, restaurants, retail – present higher risk to lenders.
  • The stability of your sales and growth – Lenders will analyze your past few months credit card receipts, as well as other sources of funds, to establish a growth pattern and average receipts. In general, they want to see that you’ve maintained or grown revenues.  
  • Average monthly credit card sales – Because a MCA lender takes their repayment as a percentage of daily, weekly, or monthly, credit card sales, they will examine your average monthly credit card sales closely. Consistent sales reassures them that you will be able to repay the loan.
  • Your business or personal credit score – A business or personal credit score measures how likely it is that you’ll repay the loan. Borrowers with lower scores which indicate past financial mistakes will pay more to borrow.

Factor rates are usually associated with riskier borrowers and higher-risk lending products such as merchant cash advances or invoice factoring. A merchant cash advance is an advance against future credit card sales, whereas invoice factoring is an advance against your outstanding accounts receivable.

Calculating a Loan’s Cost with a Factor Rate

If a lender quotes you a factor rate for a business loan, how much will you pay for it? The good news is that it’s a lump sum, so you’ll know upfront the loan’s total cost. 

If you took out a $25,000 loan with a factor rate of 1.5, you’d calculate your total cost as follows: 

Advance amount ($25,000) X Factor Rate (1.5) = Loan’s Total Cost ($37,500)

If you subtract the loan amount of $25,000 from the total cost of $37,500, you’re paying $12,500 for the loan. Because most lenders build the loan’s cost into the advance amount, they do not charge a prepayment penalty if you pay it off earlier. The higher cost of loans that charge factor rates is a reflection of their risk.

Lenders that charge factor rates are taking on a much greater risk with these types of loan products. The loan requires no collateral, and if it has no personal guarantee you could default and the lender would have no way to recoup their money.

Legal Matters and Factor Rates

Most states have usury laws which regulate loan transactions. These laws place caps on the interest rates that lenders can charge. However, since merchant cash advances aren’t loans these laws don’t apply. Some lenders purposefully only offer these types of advances in order to get around the laws and charge for the borrowed capital.

As well, because repayment on MCAs are conditional they are further exempt from usury laws. With a small business loan, payment is required no matter what happens with your business. But payments on a merchant cash advance depend on future credit card sales, and if you didn’t sign a personal guarantee you might not have to repay the advance if your business fails.

Converting a Factor Rate into an Annualized Interest Rate

If you want to know how the factor rate you’re paying would be shown as an interest rate, follow these steps. 

  1. Calculate the total payback amount (loan X factor rate).
  2. Subtract the loan amount from this total to get the loan’s cost.
  3. Divide this cost by the loan amount to get a percentage.
  4. Multiply this percentage by the number of days in a year and then divide it by the expected repayment period.

If we continue with our example above, we have already performed the first two steps. The $25,000 loan costs $12,500. Divide $12,500 by $25,000 to get 0.50. Multiply by 365 for 182.5. Let’s say that loan will be repaid over three months, or 90 days. When you divide 182.5 by 90, you have 202.7%.

This means that you would be paying over 200% interest on the advance if you did this loan 4 times in the same year with the same terms. It is important to understand that this is just a representation through an annual lens to give consumers a way to compare with other financial products. You would pay much less on a short-term business loan from a traditional bank, but in today’s banking environment it is hard to qualify for one. As well, you may need the money quickly and not have months to wait on a bank loan.

Quick Answers to Questions about Factor Rates

Just want the facts? Here are the answers to some quick questions about factor rates.

What is a factor rate? 

A decimal representation of what a lender will charge on the sum of money you’re borrowing. An example would be 1.2 which represents the full amount plus 20%.

How do I calculate a factor rate?

Take the loan amount and multiply it by the factor rate. As an example, $10,000 borrowed at a 1.2 factor rate repays $12,000.

When is a factor rate a better choice than an interest rate?

It could be easier to calculate the total cost of your loan with a factor rate – unlike an interest rate, there aren’t hidden fees, and making extra payments or paying off the loan early won’t change the loan’s cost. As well, if you need money quickly the loan products that charge factor rates typically fund much faster than a traditional loan.

What determines the factor rate a lender charges me?

The lender will look at how long you’ve been in business, your average monthly credit card receipts, your business and personal credit score, and industry.

The high cost of a merchant cash advance doesn’t necessarily mean that you shouldn’t take one out – in many cases, it could be the best choice for your business. But a savvy business owner should know their cost of capital before borrowing.