Calculating Merchant Cash Advance Factor Rates
“Congratulations, you have been approved for a merchant cash advance.”
The agreement shows up in your email inbox and you print it to read in detail. It appears to be in another language of sorts. Quickly you realize that you do not understand the terms and fees and you can’t quite figure how much the money you will be receiving is truly going to cost you. You have never heard of the term factor rate and you simply want to understand the basic terms and for those terms to make sense.
Hopefully, we can help you decipher the seemingly inconsistent numbers you are seeing. With more clear information, you can then make an informed decision whether these extremely high interest rate merchant cash advances are right for your business.
Interest Rates Versus Factor Rates
Most business owners are very familiar with the term” interest rate”. Many have calculated interest rates associated with a credit card or a mortgage.
Interest is effectively the amount of money you pay to use someone else’s money, calculated over time. Interest rates are expressed by a percentage and you can normally pick up a calculator to compute how much you would pay to utilize borrowed money over a particular period of time.
For example, with 10% interest on a $100.00 loan, you would pay back $110.00.
Merchant cash advances do not use a typical interest rate to calculate the use of funds. They use what is called a “factor rate”.
A factor rate also calculates how much you will pay for borrowed money, but it is expressed as a decimal figure or a multiple. The calculation may be noted as a 1.2 or 1.5 factor. Factor rates typically range between 1.2 to 1.5. Basically, that is designed to suggest that you will pay back 120% or 150% of the money you borrowed.
When using interest rates, the rates will be recalculated over the term of the loan as you make payments. A factor rate is calculated at the beginning of the loan and never changes.
For example, if you received a $40,000.00 merchant cash advance at a 1.20 factor rate, you would multiply $40,000.00 X 1.20 = $48,000.00. This means the cost of the advance is $8,000.00.
Being that you and most business owners are accustomed to using percentage rates, we will guide you how to convert a factor rate to an annualized percentage rate (APR).
Converting the Factor Rate to Annualized Percentage Rate (APR)
Below we will compare an interest rate on a standard loan to a factor rate with a merchant cash advance.
For the example, we will use a $20,000.00 merchant cash advance at a 1.3 factor rate with a repayment period of 180 days.
Step 1: Calculate the Total Cost of the Merchant Cash Advance
This step will help us figure out the total amount of money you will need to pay back to the lender based upon the factor rate. In this step, you multiply the amount you are being loaned by the factor rate to get the total amount. The formula looks like this:
The amount of the advance (X) The factor rate = total cost of the merchant cash advance
Using our example of a $20,000.00 advance, we can calculate the following:
$20,000.00 X 1.3 = $26,000.00
Step 2: Calculate the Actual Cost of the Merchant Cash Advance
Now we will calculate the amount of money you will be paying back beyond the amount loaned to you. The formula to do so looks like this:
Total cost of the merchant cash advance (-) the amount loaned to you = actual cost
$26,000.00 – $20,000.00 = $6,000.00
Step 3: Calculate the Percentage Cost of the Advance
Use the following formula:
Actual Cost of the merchant cash advance (/) by the principal amount = percentage cost
$6,000.00 / $20,000.00 = 0.3
Step 4: Calculate the Annualized Interest Rate
First we will get the rate over the course of a year using this formula:
Percentage cost multiplied by 365 (every day in the year) = x
.3 x 365 = 109.5
We will then divide that number by the number of days in the repayment period to get the Annualized Interest Rate.
x / the expected repayment period (in days) = Annualized Interest Rate
109.5 / 180 = .6083 or 60.83%
What this means in the example above is that if you were to borrow $20,000.00 in the form of a merchant cash advance, you will be paying a 60.83% annualized interest rate for the use of that money.
Calculating the True APR
The true APR is calculated by adding in all of the other fees also included with the advance. Not just the repayment amount but also the other “junk” fees that most certainly will be included with the merchant cash advance loan.
Generally, there are many hidden fees contained within most merchant cash advance agreements. Some funders utilize origination fees, others charge for document preparation fees, and some also charge for what are referred to as processing fees.
The merchant cash advance companies tend to be very creative in formulating and hiding extra fees in their agreements. You need to be aware that those extra, and meant to be confusing fees, that are hiding in every merchant cash advance agreement.
All potential borrowers need to closely examine any proposed merchant cash advance agreement in order to determine the true cost of borrowing money in the form of a merchant cash advance. You must add up all of the fees and costs of loan repayment and divide those total costs over the time period of repayment, in order to calculate your estimated APR.
The shorter the term of repayment, the higher the APR. For example, a $100,000.00 advance with a 1.28% factor rate and with 2.5% in fees over a 12 month term, calculates as an APR of 59%. The exact same loan with the same fees over a shorter 6 month term, calculates as an APR of 118%.
Always Calculate the Cost of a Merchant Cash Advance
We do understand that it may be difficult merely following the examples we have laid out here. Fortunately, there are various merchant cash advance calculators around the internet to help you quickly decipher what your interest rate and APR would be with a proposed merchant cash advance.
Please always run your calculations and understand what borrowing the funds will actually cost you before you sign any documentation. Merchant cash advances are very expensive loans and you need to be aware of the actual costs of the proposed advance/loan, before you move forward.
Unfortunately, many borrowers are only concerned about the daily debit withdrawal payment they will be making rather than the actual costs of the advance. You should be greatly concerned about what you will be paying for the money you will receive.
How is the Factor Rate Determined?
If you are a savvy business owner and you are interested in the true cost you are going to pay for your advance, you need to learn what controls the calculation of a merchant cash advance factor rate. So, what does determine your factor rate?
- Average Monthly Credit Card Sales – You will be asked to supply 3 months business bank statements to prove that you will be able to pay back the advance proposed to you. If the funder sees strong sales, demonstrating that it is highly likely that you will be able to pay the advance back, your factor rate will be lower.
- Length of Time in Business – Many merchant cash advance lenders require you to be in business for at least 12 months. There are some that only require as little as 3 months. The longer you have been in business, the more likely you will be able to continue doing business and pay back any proposed advances. The longer you have been in business, the better the factor rate you will be offered.
- Business Industry – There is much more risk associated with certain types of businesses. This plays a vital role in the rate that you may be charged. The more risky or volatile the industry, the higher the factor rate.
- Personal Credit History – Many merchant cash advance funders will pull your personal credit history in order to gauge how responsible you are regarding repaying your debts. Lower credit scores will usually raise your factor rate. Higher credit scores may lower your factor rate.
As you can see, merchant cash advance funders use factor rates instead of percentage rates because they wish to avoid being regulated like a traditional lender and so a potential borrower will not recognize the true annualized percentage rate (APR) on any proposed advance/loan.
If all borrowers understood the actual true costs of borrowing money from a merchant cash advance lender, it would likely deter many from taking the advances. If a merchant cash advance lender tells you that they will lend you $50,000 to be repaid in 6 months at a 173% interest rate, how likely would you be to accept the money?
Any traditional loan is required by law to show you the APR you will be charged for any loan product. Merchant cash advances are not regulated or restricted by any state or federal laws at this time and their ability to deceive and misguide you is all too common.
We advise you to steer clear of merchant cash advances and search for any other type of alternate funding as a better option. If your business’s financial stability is on the line and your last resort is to take out a merchant cash advance, take the time and understand what you are getting yourself into.
Business Debt Law Group is always available for complimentary consultations to help you any way that we possibly can.