Businesses of all shapes and sizes require financing. In your own search for capital, you may find yourself buried in countless loan options with varying repayment structures. Factor rates are one such option for repaying short-term business loans.
So, is a factor-rate loan the right option for your business?
What is a factor rate?
Factor rates are used to calculate how much a borrower owes on a given loan. These types of rates are typically used with merchant cash advances and other forms of short-term business funding. They differ from interest rates in the way they’re expressed and how they’re calculated.
For one, factor rates are formatted as decimals where interest rates are shown as percentages. Factor rates are also fixed (i.e. all of the interest is calculated using the original loan or advance amount) while interest rate scales based on the size of the principal, accruing on the remaining balance as payments are made.
How does a factor rate work?
Factor rates usually range anywhere from 1.1 to 1.5.
principal x factor rate = total amount owed
Let’s say you take out a loan of $10,000 at a factor rate of 1.3. The total amount owed at the end of the loan is the loan amount times the factor rate.
$10,000 x 1.3 = $13,000
In this case, the cost of borrowing is fixed at $3,000, assuming the loan is paid off on time. How and when you pay back the money borrowed will also vary based on the loan’s terms. If the length of the loan is 14 months and terms state that payment should be made monthly, the borrower would owe approximately $929 per month.
$13,000 ÷ 14 = $928.57
Other lenders may require that payments are deducted weekly or even daily. With some merchant cash advances, lenders even provide the borrower with their own credit card terminal, deducting a percentage of repayment from each transaction.
How factor rates can balloon
Factor rates can sometimes seem like a better deal because of how they’re structured. When annualized, though, it’s easy to see how costly factor rates can be relative to interest rate-based term loans. This is why APR (annual percentage rate) is the best metric to evaluate the true cost of a loan and the most effective way to make an apples-to-apples comparison of different financing products. Below is an example of how to calculate APR on your own, but there are also numerous calculators available to help you out.
Using the example above, again consider a $10,000 loan with a factor rate of 1.3.
$10,000 x 1.3 = $13,000
You’d pay $3,000 in interest for a total payback of $13,000 for a percentage cost of 30% ($3,000 ÷ $10,000).
To annualize the rate, we first multiply 30% by 365 days in a year, or 109.5. Then we divide by the total repayment period in days by that number. We’ll again assume a payback period of 14 months or about 420 days for an APR of 26%. This percentage is high relative to most credit cards, and it can very easily increase depending on the terms of the loan.
109.5 ÷ (30 x 14) = .26
.26 x 100 = 26% APR
Imagine if you took out at advance which was being paid back via a percentage of your daily credit card sales. Business is booming, so you can pay back what you borrowed in seven months instead of the full 14 months:
109.5 ÷ (30 x 7) = .52
.52 x 100 = 52% APR
Converting the factor rate into APR shows how expensive it can be compared to other alternatives.
If your business is in need of short-term financing to cover an emergency expense or make a small purchase such as supplies or inventory that can be paid back quickly, then a loan with a factor rate may be appropriate. They’re easier to qualify for, and funds can be received within a shorter time frame than long-term loans, which make them more accessible, especially if you find yourself in a jam and in need of cash fast.
The bottom line
Understanding what factor rates are and how they are calculated can help you determine whether or not financing with this type of cost structure will hinder business. Whereas interest rate is based on the depreciating principal and calculated multiple times throughout the life of the loan, a factor rate is calculated only once, and based on the original loan amount. Before you sign on the dotted line, you want to make sure that you’re setting yourself — and your business — up for success.