Double Dipping: The Hidden Costs of a Merchant Cash Advance
Merchant cash advances (MCAs) and short-term loans (STLs) are an easy way for merchants to borrow cash for business purposes. Although these types of financing often get a bad rap, many legitimate business funders offer merchant cash advances and short term loans.
However, because these types of funding are still relatively new and often misunderstood, some funders still attempt to make extra profits by using unfair tactics.
Double dipping, the practice of paying interest on interest, is one such tactic. If you choose to borrow from a merchant cash advance or short-term loan provider that practices double dipping, you may be losing out on a lot of money.
What is double dipping? And how do you avoid it? Keep reading to find out!
Factor Rate Basics
To understand double-dipping, you first need to understand how merchant cash advance and short-term loan borrowing fees are calculated.
Unlike traditional loans (also called installment loans), MCAs and STLs do not charge interest. Instead, they calculate your fee using a multiplier known as a factor rate (sometimes called a “buy rate” or “flat fee”).
Typically, the factor rate will be between x1.1 and x1.6. To calculate your repayment amount, you simply multiply the factor rate by your borrowing amount. For example, if you are borrowing $10,000 and your factor rate is x1.35, you will have to repay a total of $13,500 ($10,000 x 1.35 = $13,500). Unlike interest, which accrues over time, the repayment amount will not change, regardless of how long you take to repay the capital.
Because you know the total cost of capital up-front, factor rates can be a very simple way of calculating borrowing fees…if you are simply borrowing one lump sum and repay according to the schedule. However, factor rates can carry a hidden cost if you refinance your loan or advance.
What is Double Dipping?
Double dipping is primarily a problem when you are requesting additional funds, refinancing, or renewing your merchant cash advance or short-term loan.
As stated above, double dipping is paying interest on interest. When you refinance, your financial provider will use funds from your new loan or advance to pay off the balance on your old loan or advance. Because products with factor rates have a pre-determined payback amount, your funder may be using a portion of your new funds to pay down the remaining, unpaid, fee in addition to the principal. In doing so, the funder is driving up the cost of the new loan and you are effectively paying interest on top of interest.
Confused? Perhaps a diagram will help.
Here is the amortization schedule for a $10,000 loan, with a factor rate of x1.35 and a repayment term of six months. Although short-term loans are typically repaid each weekday, for brevity’s sake, the chart shows roughly how much is going toward the principal and how much is going toward fees per month.
Although it is possible to calculate how much is going toward the fee and how much is going toward the principal for each payment, because the total fee is pre-determined, borrowers typically do have to pay the full fee even if they repay early (however, if the lender has a prepayment discount, the borrower could save money by repaying the loan before maturity).
If your provider double dips, the problem is compounded. You’ll have to pay fees on top of the fees. Let’s look at the difference between a provider that double dips versus one that forgives the remaining interest when the loan is refinanced.
For this example, the merchant has requested an additional $5,000 after they have been paying the loan off for three months. Instead of offering a separate loan, the provider consolidates the debt by paying off the old loan with the new loan. I am assuming the factor rate is still x1.35.
|Calculation||NO Double Dipping||Double Dipping||Difference|
|Total loan remaining:||(principal + interest)||$4,051||$4,501|
|New loan cost:||(total loan remaining + new funds requested)||$9,051||$9,501||$450|
|New total repayment amount:||(new loan cost x factor rate – total loan remaining)||$8,168||$8,325||$158|
After three months, the merchant has $4,051 remaining for the principal, and $450 remaining in interest.
A lender who doesn’t double dip will waive the interest, so to pay off the old loan and give the merchant an additional $5,000, the lender will have to issue a loan of $9,057 ($4,051 + $5,000). On the other hand, a lender who does double dip will have to issue enough to cover the principal and interest in addition to the $5,000, for a total new loan amount of $9,501 ($4,051 + $450 + $5,000).
The merchant with the double dipper has already lost out on $450 of unpaid interest, but that’s only half of it—they still have to pay interest on the new loan.
Assuming the factor rate is still x1.35, the loan without double dipping will have a total repayment amount of $8,168 ($9,057 x 1.35 – $4,015) after the old principal is paid off. The loan with double dipping will amount to a total of $8,325 ($9,501 x 1.35 – $4,501) when the old principal and interest are paid down.
Because the interest was not waived, the merchant in the double dipping situation will have to pay an additional $158 on a new loan. Including the unpaid interest from the old loan, the merchant is losing $608 ($158 + $450) for no other reason than paying interest on top of interest.
How Do I Avoid Double Dipping?
The only way to avoid double dipping is to find a funder that does not participate in double dipping before you borrow capital. After you have taken out a loan or advance, you are committed to repaying the money regardless of the terms.
Don’t know if your funder double-dips? Just ask! Your funder should be able to tell you whether or not the fees are waived on renewal and provide a detailed breakdown of the renewal process.
If you are currently working with a funder who double dips and you need additional funds, you may want to look to refinance with another funder. Although you may have to take a hit on interest charges, you will not have to deal with the same problem in the future.