What Is A Factor Rate On Small Business Financing? How To Understand The Cost Of Borrowing
You’ve had a mortgage or a car loan and have the basics down: monthly payments, principals, interest rates. But one day you start browsing business loans and you come across a “rate” that looks something like “1.3”. There’s no percentage symbol and the number’s too small to make sense as an interest rate. So what the heck are you looking at? Buddy, you’ve just discovered factor rates.
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What Is A Factor Rate?
Typically, you’ll see factor rates associated with short-term loans and merchant cash advances, although they occasionally pop up elsewhere.
Overall, factor rates provide an easy and straightforward way to calculate fees. Substantially easier than figuring out interest rates, in point of fact. Maybe a little too easy…
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. Not only that, but the simplicity itself can disguise just how high the cost of borrowing actually is.
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.
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. Where it gets tricky is that you probably will have a higher factor rate the longer your term is, so in some ways you can think of the interest the loan would have accumulated as being “baked in” to the factor rate.
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.
Potential Factor Rate Issues
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.
Simplicity has its costs. 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, or effectively reduced if you overpay along the way.
Fortunately, many lenders that use factor rates do actually offer discounts to merchants who repay their loans 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. Just don’t assume they’ll do it unless they explicitly say so.
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 quasi-lines 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.
How To Evaluate A Factor Rate Offer
Comparing one factor rate to another is actually really easy: the lower the factor rate, the cheaper the loan. What this doesn’t account for, however, is additional fees (such as origination fees) and how punishing your repayment schedule will. For example, it’s harder to pay off a loan with a 1.3 factor rate in three months than it is in six months. And what happens if you need to compare a loan with a flat factor rate to a loan with an interest rate? Can you compare apples to oranges? No, but you can dress an apple up as an orange and compare their skins.
Repurposed fruit cliches aside, the go-to tool for comparing financial products is the annual percentage rating (APR). Expressed as a percentage–not to be confused with an interest rate or a factor rate–it’s a rough estimate of the yearly costs of a loan. Be aware, the APR isn’t a perfect fit for short-term loans as the short repayment periods will drive the APR up significantly. Needless to say, if you’re looking at short-term loans, be prepared to make daily repayments.
One nice thing about APRs is that they factor in those supplemental fees we talked about earlier. So if a loan has a relatively low factor rate but tons of hidden fees, that will raise the loan’s effective APR.
The higher the APR, the more expensive the loan.
As we covered above, you’ll also want to consider whether the lender double-dips and offers early repayment incentives, as these won’t be reflected in your effective APR.
Factor Rate Calculators
So how the heck do you calculate APRs? You can either dive into spreadsheet formulas, or you can cheat and use one of our handy calculators! You can use the embedded ones below, or go to our MCA calculator or STL calculator pages.
While MCAs and short-term loans share a few qualities, they are different financial products, so I recommend using the appropriate calculator above.
The top field in both calculators is simply the amount that you’re receiving from your funder, not including added or subtracted fees. You can select either the total payback amount or, if you don’t have that number handy, just enter your factor rate and the calculator will make the conversion for you.
From here, the calculators differ a little:
- Administrative Cost (MCA): A fee for servicing your advance.
- Monthly Credit Card Sales (MCA): Your average monthly card-based sales. Because MCAs have no definitive term length, they’ll last longer if you have a bad month, and shorter if you have a good one.
- Percentage of Daily Sales Withheld (MCA): This is the cut your funder will take out of your daily card-based sales each day. You can think of it as roughly correlating to a term length on a loan. The higher the percentage, the shorter the term.
- Number of Payments (STL): The estimated number of payments you’ll be making for the life of the loan. Typically, daily payments are only made on business days.
- Repayment Frequency (STL): Select one from the pulldown menu.
- Origination Fee (STL): This is a weird one. Your origination fee, if there is one, is subtracted from the lump sum the lender gives you rather than charged in addition to it. It’s effectively the same thing, just be prepared to get less money from your funder than you’re anticipating.
- Miscellaneous Fees (STL): Add together any fees that aren’t an origination fee and enter them here.
The calculators will return some useful information for you.
- An Effective APR: A percentage approximating the total annual cost of borrowing. Useful for comparing different financial products.
- Total Repayment: The amount of money you’ll be paying back (the amount you received + fees/interest).
- Approximate Daily Repayment (MCA only): The amount your funder will take from your card-based sales on a given business day.
- Approximate Days To Repay (MCA only): An estimate of the number of days it will take you to settle your advance based on average monthly sales.
- Financing Cost: The amount the product will cost you (fees and interest without the principal).
- Cents On The Dollar: The amount you’ll have to pay back for every dollar you borrow.
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: