Need to access cash for your business? Well, you know that when you take out a loan or use a credit card, you’ll have to pay interest on the money you borrow. The interest percentage depends on the type of financing, market conditions, and your credit score. However, not all loan types express interest with an annual percentage rate. Instead, some use a factor rate. What is a factor rate and how does it compare to a standard interest rate? Read on!
What Does Factor Rate Mean?
Factor rate is just another way of expressing the amount of interest a lender charges on a loan. Interest rates are usually expressed as percentages, whereas factor rates are expressed as a decimal number (e.g., 5% vs. 1.2). A factor rate lets you know the true cost of a loan. Multiply your loan value by the factor rate and you’ll arrive at the full amount you’ll need to pay back to your lender (principal plus interest).
How Are Factor Rates Determined?
As with interest rates, lenders take a number of elements into consideration to arrive at a factor rate.
Industry: Is there a high demand for your type of business? Do customers generally pay on time? Do customers usually pay with cash, check, or credit card for your goods/services? Are you selling direct to consumers or in large quantities to suppliers? These all impact your repayment ability and lending risk.
Business history: Most lenders will not do business with a brand new company. They want to see some stability and a track record, so many lenders require that your business be at least 6 months to 1 year old—traditional lenders like banks and credit unions want to see several years. More established businesses will likely have more options.
Internal financial documents: Lenders will review accounting records to get a handle on your sales trajectory and growth potential. They want to be sure you will have enough money coming in to make your payments.
Bank statements and tax returns: 3 months of bank statements will help a lender assess the current financial health of your business. Your latest 2 tax returns allow a lender to evaluate the direction your finances are trending.
Credit card statements: If you’re seeking a merchant cash advance, your lender will want to review a 6-month history of your electronic fund transfer records. This will illustrate how much money you have coming in via credit card and if/how these sales have changed over a period.
Generally, a borrower with a longer business history and a positive sales trajectory will be able to score lower factor rates. This is because the risk to the lender is lower. A lender will charge more interest when uncertainty exists surrounding the business’ success and likelihood of repayment.
Does My Credit Score Impact My Factor Rate?
Depending on the lender and type of loan, your credit may be checked when applying for a loan that uses factor rate to determine interest. A merchant cash advance is the most popular type of financing that uses rate factoring. For this kind of borrowing, the lender is more interested in your recent financial records than in a lengthy history of your business’ finances. For these purposes, electronic transfer records and recent bank statements will do the job more accurately than a full credit report. However, some lenders may have a policy to do a credit check on all borrowers. If you’re curious where you stand when it comes to credit, consider checking out your free business credit scores online.
How Do You Calculate Your Loan Factor Rate?
To figure out the total cost of your financing using the factor rate, multiply the total amount borrowed by the factor rate. For example, if you borrow $100K at a factor rate of 1.3, the total total cost of the financing is $113K, meaning you’ll pay $13K in interest. To calculate your monthly payment obligation, divide the total loan value by the number of months in the loan term. If the above term was 2 years, your monthly payment obligation would be $4708.33 ($113K divided by 24 months).
You’ll want to make sure any fees are included within the factor rate calculation. Otherwise, any fees or other charges will need to be added to the total cost of financing. You should also be aware than most Merchant Cash Advances debit from your merchant account on a daily basis, not in a single monthly payment. You may also want to look at some of the other costs associated with a Merchant Cash Advance to make sure they are all captured within the quoted factor rate.
How Does Factor Rate Differ from Interest Rate?
Aside from the way it is expressed, there are some differences between factor rates and interest rates. Primarily, some interest rates compound while factor rates do not. Certain loans with interest rates have compounding periods when interest is re-calculated based on the remaining loan balance. Generally, this means you are paying less interest overall as your repayment accrues and the loan amount decreases. Factor rates do not compound over the repayment period nor do fixed interest rate loans.
Additionally, many interest rate loans are amortizing while factor rate loans are not. Amortization refers to the process of paying down the principal of a loan to lower monthly interest payments. Though the borrower’s expense is usually the same from month to month and the annual percentage rate APR does not change, the lender calculates amortization behind the scenes to offer the best overall value to the borrower.
What Types of Financing Use Factor Rate?
The most popular types of financing that use factor rates are:
Merchant cash advance: This financing type allows a business to quickly access cash based on its future credit card sales. The lender is repaid by automatically deducting money from the borrower’s electronic fund transfers. The cost to the borrower is comprised of the factor rate and other transfer fees.
Invoice factoring: This method of financing lets businesses get immediate access to money by essentially selling their invoices at a discount to a factoring company. The factoring company collects on the invoices and charges fees to the borrower.
Short-term loan: Loans with short terms are typically associated with alternative or online lenders. Businesses often use them to help with temporary cash flow needs. The borrower’s cost involves interest and fees. Because the loan period is so short, lenders will qualify a borrower with a shorter track record, so a younger business with only a year under their belt can be approved for a loan.
Other common loans – such as a real estate mortgage, working capital loan, line of credit, and equipment financing – do not use factor rates.
Nav’s Final Word: Factor Rates
If you are searching for business loans for small business, it’s important that you understand factor rates, as some popular financing methods employ this means of calculating interest. Factor rates allow you to very simply compute the true cost of a business loan. Your factor rate will be determined by an assortment of elements depending on your lender’s preferences. Some of these include your credit rating, recent credit card sales, and bank statements. The lower the lending risk, the lower your factor rate will be.
Invoice factoring, short-term loans, and merchant cash advances are a few of the business financing options that use factor rates. Before pursuing these or any style of loan, consider checking your business credit report to understand your overall financial standing and how it may limit or broaden your options.
Business loans can help grow your business or pull you through a tough time. It pays to have your finances in order and a healthy understanding of your business credit so you can take advantage of business lending when your company is in need.
This article was originally written on March 23, 2020 and updated on October 21, 2020.