Last Updated on March 29, 2024
Shield Funding TeamThe 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.
A factor rate is used in place of interest rates because many non-bank lenders do not charge interest on borrowed funds. A bank charges interest and will express the loan’s cost as a percentage – for example, a rate of 5.50%. But a non-bank lender that charges a factor rate will show it as a decimal number, typically between 1.2 and 1.5. This type of rate is commonly utilized in non-bank financial products such as merchant cash advances and short-term business loans. Factor rates simplify the cost calculation process, making it easier for borrowers to understand the total repayment amount upfront.
Factor rates are typically expressed as decimal numbers, most commonly falling between 1.2 and 1.5. This decimal figure is used to calculate the total repayment amount of the loan or advance. For example, a factor rate of 1.2 indicates that the borrower will repay a total of 20% on top of the borrowed amount. The “1” represents the entire amount borrowed or principal that will be paid back, and the “.2” which is the same as 20% represents the fee for the advance.
Interest rates, annual percentage rates, and factor rates are all associated with borrowing costs but are calculated and applied differently.
Interest Rates: The interest rate in regards to borrowing is the amount a lender will charge and is quoted as a percentage of the principal amount. Interest rates are generally used to determine the APR on the loan, but may be used to just determine the amount paid on top of the principal. However, it’s important to note that an interest rate does not include additional costs that could be incurred in a loan, such as various fees or compound interest.
Annual Percentage Rate (APR): APR is a broader measure of the cost of borrowing money than the interest rate alone. It includes the interest rate and most of the additional fees associated with a loan, giving a more complete picture of the annual cost of a loan. It is important to note that there may be some fees that are not included in the APR as there is some regulatory leeway for lenders reporting every single fee. Overall, it reflects a very close approximation if not the exact cost of borrowing on an annual basis, including most fees or additional costs associated with the transaction. The main highlights of an APR is that it is a standard measuring tool across a wide variety of lending products so it is a good way to compare financial products that are offered with an APR.
Differences Between the Three: Interest rates purely reflect the cost of borrowing on top of the principal and can lead to different actual costs depending on how often the interest is compounded (e.g., daily, weekly, monthly) and what other fees may be involved. APR gives a more complete picture by including both the interest rate and other fees, which can provide a more accurate sense of the yearly cost of a loan. Factor rates, on the other hand, offer a fixed cost of borrowing, which is easier to understand upfront but may not reflect the total cost of borrowing over time as accurately as APR because it does not consider the reducing balance of the loan or the duration of the loan. However, factor rates are a bit easier to understand as it is details exactly what will be paid on top of the principal as there is no compounding interest fees.
The first choice in borrowing when presented with these different types of quoted percentages is the option that comes with an APR, or a product with a clear interest rate and fees where APR can be calculated easily, which will definitely be the most affordable. If you are considering a financial product with a factor rate chances are you cannot obtain traditional financing or you have exhausted those options.
It is important to emphasize that each situation is different. If time is a major issue than a factor rate (often quoted with annualized percentage rate) product could be a perfect fit. If an opportunity presents itself and the math of borrowing makes sense, this is another example where a factor rate can be a great choice.
If you have any doubts about which of the above your lender is planning to charge for your loan, ask them for clarity.
The factor rate that a lender decides to charge you depends upon:
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.
If a lender quotes you a factor rate for a business loan, a merchant cash advance, or any other short term lending product, 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) = Total Payback ($37,500)
If you subtract the loan amount of $25,000 from the total cost of $37,500, you’re paying $12,500 (50% on top of the principal) 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.
This simplicity in calculation allows businesses to have a clear and upfront understanding of their total repayment obligations, aiding in better financial planning and management. It eliminates the complexities that often come with interest rates and APR, such as compounding, making the borrowing process more transparent.
If you want to know how the factor rate you’re paying would be shown as an annualized interest rate, (which is not the same as APR but gives you a reasonable number for comparison) follow these steps.
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.
If you want to take it a step further toward exact calculations you can get a close approximation of the APR, which is different (can be higher but more accurate) from the annualized interest rate on your short term lending product by converting a factor rate to an APR.
Most states have usury laws which regulate loan transactions. These laws place caps on the interest rates that lenders can charge. It is important to highlight that since many short term business funding options today that use factor rates aren’t structured as loans these laws don’t apply. This means that you should get educated on exactly what borrowed capital will cost you and consult with your financial advisor or accountant before any type of significant borrowing.
It is also worth noting that some lenders can only offer these types of funding solutions in order to avoid the strict regulations associated with traditional business loans. There would be no alternative borrowing if the factor rate structured financial products did not exist as many banks make it impossible for most small and medium sized businesses to borrow. It is a risk/reward scenario, and the lower you are as a risk the cheaper the cost of borrowing, whether factor rate or APR.
Take the loan amount and multiply it by the factor rate to get the total repayment amount. As an example, $10,000 borrowed at a 1.2 factor rate repays $12,000. Now just subtract the principal taken, so ($12,000 – $10,000 = $2,000).
No, they are completely different and should not be used to compare products. Follow the link if you want to manually convert APR from your Factor Rate.
It could be easier to calculate the total cost of your loan with a factor rate – unlike an interest rate, there are no hidden fees or ambiguous calculations of compounding interest, and making extra payments or paying off the loan early won’t change the loan’s cost. Also, if you need money quickly the loan products that charge factor rates typically fund much faster than a traditional loan and have much more flexible credit requirements.
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.
