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Updated: November 13th, 2020
Rather than charging interest on a small business loan, some financing companies use a factor rate to determine how much you will be charged to borrow money from them. Most commonly, you’ll see a factor rate with short-term business financing options, such as merchant cash advances and working capital loans.
Understanding how a factor rate works, how it differs from an interest rate, and how you can convert a factor rate to an annual percentage rate (APR) can be important when you’re looking for financing.
Similar to how interest rates and APRs can help you understand the cost of a business loan, a factor rate will largely determine how much you will end up paying when you secure certain types of business financing.
For example, if you borrow $10,000 with a 1.3 factor rate, you multiply 10,000 by 1.3 to find that you’ll repay $13,000 — $10,000 of principal and $3,000 in finance charges. However, the factor rate doesn’t tell you the total cost of financing as lenders’ fees aren’t included in the factor rate.
Most often, factor rates are associated with merchant cash advances (MCAs), which are an advance on your business’ credit and debit card sales rather than a loan. However, factor rates are sometimes used with short-term business loans, such as working capital loans, that businesses take out to pay for supplies, payroll and other everyday expenses.
Sometimes, you’ll also see a factor rate in reference to invoice factoring, another type of business financing, which provides an advance on your outstanding invoices. However, invoice factoring fees are more commonly referred to as factoring fees, advance rates, or discount rates.
Factor rates are different from interest rates and APRs in several important ways:
Factor rates often range from about 1.1 to 1.5 for MCAs and working capital loans. In other words, for every $1,000 you receive, you may need to pay back an additional $100 to $500.
Comparing several offers can help you determine which company will give you the most favorable terms. In part, the factor rate you receive may depend on several criteria:
In general, businesses with the least amount of risk can qualify for the lowest factor rates. For example, if you have an established and profitable business, you’ll be more likely to get a lower factor rate than if you have a brand-new business without an established track record.
If you’re comparing business financing options, you may want to compare the total cost of an MCA or working capital loan that uses a factor rate to an interest-bearing loan. To do this, you can convert the factor rate to an interest rate in a few simple steps.
As an example, we’ll use a $10,000 advance with a 1.3 factor rate:
These three steps can turn a factor rate into an interest rate. However, you must also take into account other financing fees in order to convert a factor rate into an APR. We’ll go over this in the next section.
You will want to include any financing fees in the calculation to get the APR so that you can more accurately compare the cost of financing between multiple options. To do this, determine your total repayment amount with fees.
For example, if the lender charges a 2.5% underwriting fee and a $50 monthly admin fee, your total repayment will be $13,400. You could find this amount by adding up the $13,000 financing repayment, $250 underwriting fee, and $150 from three monthly admin fees. Then:
Then, use this new “factor rate” of 1.34 to go through the initial three steps above. If you do, you’ll find the result is 138% APR, which makes sense as it reflects that you’re paying more during the same time period.
Financing that uses factor rates often have high APRs. In part, this is because the fees and financing charges are relatively expensive. However, it’s also because they’re often short-term financing. If you took a year to pay off the same $10,000 advance, you’d pay $3,850 in total costs (a higher amount due to the monthly fee) and a 38.5% APR.
All else being equal, choosing the financing option with the lowest APR will result in repaying less money. However, “all else being equal” might not be a realistic scenario.
Lenders that use a factor rate often offer quick financing that’s relatively easy to qualify for, which may be what your business needs right now even if it’s more expensive. However, if you have an established business with good finances and credit, you may be able to qualify for less expensive financing.
If you’re unsure what will be best, comparing several financing options could be a good idea. Through Funding Circle, you apply for multiple types of small business financing through one simple application. You’ll also get your own, personal Account Manager who will walk you through the application process and help explain your financing options. Get started today!