1 May 2020
As a business, applying for a merchant cash advance can be a daunting prospect if you don’t know what to expect or how costs are calculated. In most cases, a cash advance factor rate is used to work out exactly how much a business will pay on top of the initial lump sum loan.
A merchant cash advance is a loan paid as a lump sum to a business, which is repaid as an agreed percentage of your future card transactions.
If you’ve decided to opt for a merchant cash advance, you will typically be quoted the cost of borrowing with a ‘factor rate’.
Instead of an APR, a factor rate is how a lender will tell you the total cost of a merchant cash advance as a flat fee. Usually, this is quoted as a decimal number (not a percentage) which acts as a multiplier. On average factor rates tend to start from around 1.1, going up to 1.5 and above. The rate is determined by the lender, taking into account the health and performance of your business.
As with any business loan, there are several factors that a lender will consider before giving your business a factor rate that will work both for yours and their own mutual business interest.
A lender will start by looking at how long you have been in business, along with your average monthly card payment income, and how these fluctuate month to month, year by year benchmarked by the industry.
During the process of applying for a merchant cash advance, a lender will ask for specific documents that give a picture of the health of your business which help them to forecast the growth possible in the future. With this information, lenders shape their requirements and can then calculate a merchant factor rate that is feasible and sustainable for your business specifically.
So your business has applied for a cash advance, and you have been quoted a factor rate. How does this impact the cost of your loan?
The factor rate will show you the total cost of the money you borrow and the interest you need to repay. To demonstrate, the example below will detail exactly how to figure out the complete total owed to a lender.
Your business requests a cash advance amount of £5,000 and you have been quoted a factor rate of 1.2 to be repaid over the course of a year.
This is where it can become confusing, the interest rate initially appears to be 20% but this is not how factor rates work.
A factor rate differs from an interest rate in the fact that the interest calculated is based on the initial loan amount, and doesn’t change over the course of the loan. This is why whether you repay early or not, the total interest amount does not change. Some lenders however, will give a discount on the interest if the loan amount is repaid early, essentially forgiving a percentage portion of the loan. Make sure to discuss this in advance if you think there is a chance your business may repay early.
With an APR, the interest builds on the loan amount as it is being paid off, so the amount of interest is dependent on the repayment term. When converting a cash advance factor rate to a traditional loan APR, cash advances will have a higher APR than expected. This is due to how they are structured. Referencing the example above:
You would expect the interest rate to equal 20%, but if you calculate the APR, it comes to 35.1%. Be careful when converting between factor rate and APR and make sure you are comparing the same kind of metric when shopping for a loan.
A business can take advantage of a cash advance in the short term, especially if they have a strong record of card payments month on month. A longer term secured business loan will have a lower APR but will often come with a much longer repayment term (starting from around 5 years). Additionally, a cash advance is financially unsecured, so the personal and business assets of the applicant will remain unaffected. It's the card machine and evidence of average turnover received from card payments that effectively 'secures' the advance.
When your business is in need of a quick cash injection and you’re comparing cash advances, factor rates can make it really easy to compare offerings from different lenders. A lower factor rate means a loan with an overall lower cost. Be sure to evaluate the repayment schedule as a low factor rate may be difficult to handle if you only have 3-6 months to pay it off in full. Speak with your lender to ensure that all fees are communicated in advance, the worst thing for a business is a surprise cost you weren’t expecting.