Factor Rates: Everything You Need To Know
When searching for a business loan, you might come across loans that do not have interest. Don’t get your hopes up—you still have to pay fees. The difference is, the fee is calculated using a factor rate, not an interest rate.
Factor rates are often used on short-term financial products, such as short-term loans and merchant cash advances. Overall, they’re a very easy and straightforward way to calculate fees. However, there are a few things you need to know before accepting a loan offer: loans with factor rates have to be compared a little differently than other types of loans, and the loans can carry hidden fees, which could impact the amount you’re paying to borrow money.
Read on to learn everything you need to know about factor rates!
Table of Contents
What Is A Factor Rate?
Factor rates (sometimes called a “buy rate”) are used to calculate fees for borrowing. Typically, a factor rate is used instead of an interest rate.
This type of fee is generally used on financial products with short term lengths or products that do not have a set term length—short-term loans (which have short term lengths) and merchant cash advances (which do not have a set term length) almost always carry factor rates. That said, some lenders also use factor rates for long-term products with a fixed term length, so you might encounter this type of fee even if you’re not looking for short-term funding.
Factor rates are usually written as a multiplier. You might, for example, have a factor rate of 1.2; to determine your total repayment, your borrowing amount will be multiplied by the factor rate. The calculation is as easy as that:
borrowing amount × factor rate = total repayment
For example, if your factor rate is 1.2, and you’re borrowing $10,000, your total repayment will be $12,000: $10,000 x 1.2 = $12,000. The fee for borrowing, called the fixed fee, is $2,000.
Sometimes, factor rates are written as a percentage. Using the example above, your factor rate would be 20%, meaning that the fee is 20% of your borrowing amount. Even if the factor rate is written as a percentage, be aware that a factor rate is not equivalent to an interest rate. Here are the big differences between the two:
Factor Rates VS Interest Rates
Although factor rates and interest rates appear similar, there are some important differences which potential borrowers need to be aware of.
As shown above, fixed fees (the fee determined by a factor rate) are only calculated once, before the loan is issued. The fee will stay the same, regardless of how long repayment takes. On the other hand, interest rates are accrued over time—the longer your loan is outstanding, the more fees will build up.
Factor rates and interest rates are both legitimate ways to calculate fees. However, they cannot be compared apples-to-apples. A 20% factor rate is not the same as a 20% interest rate (even if they are for a year in length). For comparison’s sake, a one year loan of $10,000 with a factor rate of 20% would have a total financing cost of $2,000, whereas the same loan with a 20% interest rate would have a total financing cost of about $1,116.
For more information on comparing loans with factor rates, check out our article on the subject.
Factor Rate Drawbacks
Although factor rates appear incredibly straightforward, some lenders use practices that are not immediately apparent, but can drive up the cost of your loan. The most common practices are prepayment penalties and double dipping.
Loans with factor rates essentially have a prepayment penalty—a penalty for repaying a loan early—baked in.
Because fixed fees are determined ahead of time, you cannot save money for repaying before your term is up. If you have a total repayment of $12,000 and a term length of 24 months, you often have to pay the full amount, regardless of whether you’re repaying in six months, one year, or after the full 24 months. So, if you choose to refinance your loan somewhere else, or simply have some way of repaying earlier than the term length, you might still have to repay the full fee.
For comparison’s sake, you can save money on loans with an interest rate. Because the fees are accrued over time based on how much money you have outstanding, the fees are halted if you pay off your loan.
Fortunately, many lenders are beginning to offer discounts to merchants who repay their loan early. Typically, the lender will forgive a percentage of the remaining fee if you repay early. For example, a lender might forgive 25% of the fee for early repayment.
Double dipping compounds the problems introduced by the inherent prepayment penalty associated with factor rates.
Double dipping is typically a problem when you are refinancing or renewing your loan. If your lender does not forgive the fee from the old loan, you are essentially paying fees on top of the unpaid fees on your old loan. Because many lenders operate like a quasi-line of credit, in which borrowers are often eligible to renew their loan or borrow more money, double dipping can become a big problem.
We walk through the process of double dipping in more detail—including the math—in our full article on the subject. But here’s the tl;dr version: if you are thinking about getting a loan with a factor rate, and are considering renewing or refinancing down the line, find a lender that does not double dip. The only way to avoid double dipping is to work with lenders who do not practice it.
Factor rates are a relatively new way of calculating fees, but they’re here to stay. Fortunately, as long as you’re aware of the few practices that can affect your savings, fixed fees are very easy to understand.
Check out these resources for further reading: