When your small business needs a short-term financing solution to boost cash flow or generate working capital quickly, you might turn to a merchant cash advance, sometimes called a business cash advance. A merchant cash advance is a loan that is paid back using a percent of your daily credit card sales. As you’re comparing the cost of this form of financing to other options such as business loans or lines of credit, you might come up against the unfamiliar term “factor rate” or “buy rate”.
A factor rate is expressed not in percentages, the way interest rates are, but as a decimal figure. Typically, factor rates vary from about 1.1 to 1.5, depending on your industry, how long you have been in business, the stability of your sales and your average monthly credit card sales.
To understand a factor rate, you should determine the total amount you will need to pay back. How? Multiply the factor rate by the amount borrowed. So, if you are getting an advance of $10,000 at a factor rate of 1.35 for a 12 month term, the total amount you’ll need to repay is $13,500 ($10,000 x 1.35 = $13,500). Knowing you’re paying $3,500 for that $10,000, at first glance, you may think you’re simply paying a 35% interest rate. But, that is not the correct way to think about factor rates. Yes, the interest COST of the loan is 35%, but when a factor rate is involved, all of the interest is charged to the principal when the loan is originated. This is why the loan isn’t priced using APR. APR is used for loans where interest accrues on the principal amount as it gets smaller and smaller as more payments are made.
The other thing to keep in mind is that there are a lot of variables with a merchant cash advance. As merchant cash advances are paid back daily (or however often you batch out your credit card system), if you have a strong sales day, you’ll be paying back more that day, versus how much you’d pay on a slower day.
Merchant cash advances are some of the most expensive loans on the market, but if you are looking for short-term cash infusion, they are certainly an option.
What does a financing company look at when determining the factor rate for your merchant cash advance? Figures include:
- Credit Card Processing Statements. The financing company will want to see that you have a solid history of substantial credit card sales. They’ll usually ask for credit card statements from the past 3 months.
- Business Bank Statements. The lender will want to verify the financial health of your business. They’ll want to see your business bank statements from the past 3 months.
- Years in Business. Most financing companies require at least one year in business before they’ll consider extending a cash advance.
- Business Tax Return. They’ll want to see your most recent business tax return to get an idea of how your business financially shapes up over the course of a year.
If you do not understand any term used in any type of financing contract you’re obtaining for your small business, don’t be afraid to ask. A good lender will be more than willing to explain terms such as “factor rate” and show you what it means in dollars and cents.
Contributor at Fundera
Rieva Lesonsky is a small business contributor for Fundera and CEO of GrowBiz Media, a media company. She has spent 30+ years covering, consulting and speaking to small businesses owners and entrepreneurs.
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