Merchant Cash Advances and APRs

APR and merchant cash advance

Small business owners searching for a merchant cash advance (MCA) or short-term business loan (STL) are often surprised to learn—after the fact—that their capital has come with a very high effective annual percentage rate (APR).

The fact that your merchant cash advance might have an effective APR of, for example, 150% can be a big surprise. After all, that’s a very large number. You may be wondering how these funders get away with issuing such expensive loans or advances.

It’s easy: they just don’t disclose the APR.

The question of whether or not funders should have to disclose APRs is hugely debated in the lending world. Merchant cash advance and short-term loan providers say that APRs are unnecessarily confusing and misleading. Everybody else says that APRs are useful for making apples-to-apples comparisons and that not disclosing APRs is misleading.

Meanwhile, merchants just want affordable capital.

Here’s the thing: APRs are very confusing. MCAs and STLs have completely different structures than traditional installment loans, and shoehorning an APR out of that structure doesn’t always work well. But these rough APR estimates are also useful for apples-to-apples comparisons… provided you know what the APR actually means.

It’s pretty clear: when you’re looking for a loan or advance, you’ll want to get an estimated APR for comparison’s sake. But to effectively make comparisons, you need to understand what APRs are for, how they work, and what their limitations are.

What is an APR?

The APR—annual percentage rate—is a number that communicates the total cost of a loan over one year. For installment loans (the most commonly used loans, which carry interest rates), this number is a reflection of the interest rate plus all the fees included in the loan. (For example, a lender might charge an origination fee, closing fee, and/or insurance fee.)

This number is important because lenders often structure their loans differently. One might charge an origination fee whereas another doesn’t, or they might have different interest rate structures. The APR is basically just a way of communicating the interest rate–plus fees–in a single, easily comparable number.

The APR works well for comparing term loans to other term loans. Here’s an example:

Loan ALoan B
Principal:$100K$100K
Term length:5 years (60 months)5 years (60 months)
Interest rate:6.5%7.5%
Other fees:$535 processing fee
3% origination fee
None
APR:8.02%7.5%
Monthly payment:$1,957$2,004
Total financing cost:$20,932$20,228

Which one is actually the better deal? Despite the higher interest rate, Loan B actually has a lower APR than Loan A. If a merchant were deciding between these two loans, they would probably want to choose Loan B.

However, Loan B may not always be the best choice. The term length has an effect on the APR as well. Here are loans with the same interest rates and extra fees, but with a term length of 10 years:

Loan CLoan D
Principal:$100K$100K
Term length:10 years (120 months)10 years (120 months)
Interest rate:6.5%7.5%
Other fees:$535 processing fee
3% origination fee
None
APR:7.31%7.5%
Monthly payment:$1,135$1,187
Total financing cost:$39,793$42,442

As you can see, Loan C is now the better choice in this scenario. Despite the fact that it comes with more fees, this loan has a lower APR because the fees are spread out over a longer period of time.

But what if you had a choice between Loan A and Loan D? Although Loan D still has a lower APR, it has a higher overall cost of borrowing. You’ll have to decide if you want lower monthly payments ($1,957 vs. $1,187 per month) or a lower overall cost of borrowing ($20,932 vs. $42,442 in fees).

Evidently, APR is not the only metric to consider when deciding on a loan. The same principal applies to merchant cash advances and short-term loans.

Calculating APRs on Merchant Cash Advances and Short-Term Loans

The obvious problem with getting an APR out of a short-term loan or merchant cash advance is that these products don’t use interest rates.

Instead, they charge a factor rate (also commonly called a “flat fee” or “buy rate”). To determine the borrowing fee, they’ll multiply the factor rate by the borrowing amount. For example, you might get a loan with a factor rate of x1.28 (also commonly written, somewhat misleadingly, as 28%). That means you’ll have to repay your lender $12,800 ($10,000 x 1.28). In other words, your fee is 28% of the borrowing amount.

If you get anything out of this article, let it be this: factor rate is not the same thing as APR. With a factor rate, the fee is calculated once based upon the original borrowing amount. With interest, the fee is accrued over time by calculating a percentage of the remaining principal until the loan is paid off.

For the above reason, you cannot technically calculate an APR on a merchant cash advance or short-term loan. However, you can still estimate it. To differentiate, an estimated APR is typically called the “effective APR.

Here are a few examples to illustrate the role of APRs in a short-term loan:

Loan ELoan F
Principal:$100K$100K
Term length:6 months (126 business days)12 months (252 business days)
Factor rate:x1.28x1.28
Other fees:2.5%2.5%
Effective APR:109%55%
Monthly payment:Approx. $21,333 ($996 per day)Approx. $10,667 ($498 per day)
Total financing cost:$28,000 ($0.28 in fees per $1 borrowed)$28,000 ($0.28 in fees per $1 borrowed)

Non-intuitive as it may be, the APR on Loan E is double the APR on Loan F, despite the fact that they both carry the same total financing cost. Because Loan E is paid off over a shorter period of time, the equivalent interest rate would be higher.

For financing with short term lengths, the effective APR does not tell you how much you are going to pay, it tells you how fast you will be paying it. A high effective APR means you’ll be repaying the loan or advance very quickly; a lower effective APR means the opposite.

Obviously, in the example above, the borrower will want to choose Loan F (unless they want to get it paid off as quickly as possible). But what if it weren’t as cut-and-dry as the example above? If you’re requesting funds from a lender, they might give you a couple different options:

Loan GLoan H
Principal:$100K$100K
Term length:6 months (126 business days)12 months (252 business days)
Factor rate:x1.2x1.35
Other fees:2.5%2.5%
Effective APR:89%71%
Monthly payment:Approx. $20,000 ($952 per day)Approx. $11,250 ($536 per day)
Total financing cost:$20,000 ($0.20 in fees per $1 borrowed)$35,000 ($0.35 in fees per $1 borrowed)

Some lenders may offer two loans to you: one with a longer term length but a higher factor rate, and one with a shorter term length but a lower factor rate.

In this example, Loan G has a higher APR, but a lower overall cost of borrowing. On the other hand, Loan H has smaller monthly payments and a lower APR, but a higher overall cost of borrowing. Which is the better loan? It depends on what the merchant is looking for.

How to Compare MCA and STL Offers

To fully understand the cost of the loan, effective APR is not enough; you will need to evaluate additional metrics as well:

  • The total cost of capital: How much do you have to pay in fees? This should include the fees calculated by the factor rate, as well as any additional fees (such as an origination fee).
  • The monthly payment: About how much are you paying per month? Because STLs and MCAs have varying payment schedules (some require payments each business day whereas others require payments each week or month) you will be able to compare loans on an even playing field if you calculate how much payments are per month.
  • The cents on the dollar cost: How much do you have to pay in fees per dollar borrowed? For example, the borrower would have to pay $0.28 per dollar borrowed for Loans E and F in the table above.
  • Prepayment discounts and double dipping policies: Does this funder give you a discount if you repay early? Or do they participate in double dipping?

The offer that is best will depend on the merchant’s needs. Do you need lower monthly payments? Or do you want to save as much money as possible? Do you anticipate that you’ll need more funds in the near future? (If so, you’ll want to find a funder that doesn’t double dip.)

A good funder will provide this information up-front so that you can make an informed borrowing decision. For example, some merchant cash advance and short-term loan providers have created a SMART Box, a standardized method for disclosing rates and fees, which includes all the information listed above (including the APR).

However, if your provider does not disclose the effective APR, you can use these calculators to get an estimate. Note that the OnDeck calculator can be used for any short-term loan.

The Bottom Line

APRs can be an important metric to consider when evaluating merchant cash advance or short-term loan offers, but should be used in conjunction with other metrics as well.

In addition to the APR, you should consider the total cost of borrowing, the cents on the dollar cost, the monthly payments, and whether or not the funder has a prepayment discount. Although this type of funding can be confusing at first glance, you will be able to make informed borrowing decisions by analyzing each of these metrics and evaluating what is most important to the health of your business.

Are you looking for a short-term loan or merchant cash advance? Whether you’re a merchant who needs cash for a seasoned business or you’re in the midst of founding a startup, we’ve reviewed a number of providers that are worth including in your comparisons (or avoiding at all cost). Check out a comparison of our favorites, or our full list of reviews.

Bianca Crouse

Bianca Crouse

Bianca is a writer from the Pacific Northwest. As a product of the digital age, she likes absorbing large amounts of information and figures she might as well pass it on. When not staring at a screen, she is probably foraging for food outside, playing board games, or harassing somebody with theories about that movie she just watched.
Bianca Crouse
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