Understanding Factor Rates and How They Work
For most loans or revolving credit facilities, the cost of financing is expressed as an interest rate or APR. Some funding options, though — primarily merchant cash advances — use a multiplier called a factor rate to determine how much you’ll repay. While the numbers look simple on paper, factor rates can make the true cost of borrowing much harder to evaluate, especially if you’re used to comparing loans by interest rates or APRs.
In this article, we’ll walk through how factor rates work, how they differ from interest rates, and how to convert factor rates into APRs to better compare MCAs with other financing options.
How Does a Factor Rate Work?
Factor rates are expressed as decimals, such as 1.2, 1.3, 1.4, or 1.5. The decimal is then multiplied by the principal amount to determine the total cost of borrowing. Let’s look at some examples.
A business owner takes out a $50,000 MCA with a 1.2 factor rate. That would mean the total payback amount would equal $50,000 x 1.2, or $60,000.
If it were a $100,000 MCA with a 1.5 factor rate, the total amount due would be $150,000.
In the first example, the business owner would pay a fee worth 20%, and in the second example, the fee would be 50%.
What Is the Difference Between an Interest Rate and a Factor Rate?
Factor rates are expressed as decimals, and interest rates are expressed as percentages — but the differences don’t stop there.
Factor rates are set, which means they don’t compound, and no matter how quickly you pay back the amount of money you borrowed, it doesn’t change how much you owe.
Interest rates, however, can compound, though some loans use simple interest. Plus, you might be able to pay less overall by repaying your loan early. Just be sure to check your loan terms to ensure there isn’t a prepayment penalty that would offset any interest savings.
Since factor rates and interest rates are different, how can you compare financing products to ensure you’re getting the best deal?
The simplest method is to convert the factor rate to an annual percentage rate (APR) and then compare it to a loan’s annual percentage rate. An APR is a standardized measure of the yearly cost of borrowing, including both interest and additional fees like closing costs or origination fees.
How to Convert a Factor Rate into an APR
There are two equations you can use to convert a factor rate into an APR. The first method is a simpler calculation that uses the factor rate alone and gives you the annualized interest rate, which is the APR without fees.
The second method allows you to include any additional fees you’ll be charged. This is better for comparing an MCA against another finance product’s APR, which also includes fees.
Simple Conversion Method
The simpler equation is {[(Factor Rate – 1) x 365] / Estimated Repayment Period in Days} x 100 = APR without fees
For example, if you have an MCA with a 1.4 factor rate that will be repaid within six months (or 180 days), the APR without fees would be: {[(1.4-1) x 365] / 180} x 100 = 81.11%
As you can see, that’s a pretty high APR.
Complex Conversion Method
Now let’s say you’re taking out a $50,000 MCA with a factor rate of 1.3, a 2% origination fee (or $1,000), and an estimated repayment period of 90 days. You’d want to use a more complex equation that takes the fees into account. We’ll break it down step by step:
Start by multiplying the MCA amount by the factor rate: $50,000 x 1.4 = $70,000
Take that result and add any fees: $70,000 + $1,000 = $71,000
Subtract the MCA principal amount from that total: $71,000-$50,000 = $21,000
Divide that total by the MCA principal amount: $21,000 / $50,000 = .42
Divide that decimal by the estimated repayment period in days and then multiply the result by 365: (.42 / 90) x 365 = 1.7033
Multiply the total by 100 to get the APR percentage: 1.7033 x 100 = 170.33%
Is APR the Only Factor to Consider When Comparing Finance Options?
APR is a great way to compare two finance products, but some argue that it doesn’t tell the whole story when comparing short-term products or when compounding varies. If you want to take your comparison a step further, you should look at the total cost of a loan or business funding.
Let’s take a look at how we’d calculate the total cost and compare two different finance products:
A $50,000 business term loan with a 10% interest rate that compounds monthly and has a one-year term
A $50,000 MCA with a 1.3 factor rate and an estimated repayment period of six months (180 days)
For simplicity, we’ll assume neither the loan nor the MCA has additional fees, but in most cases, they will, so be sure to consider the cost of all fees in a real-life comparison.
Business Term Loan Cost Example
We’ll start with the term loan. To calculate the total cost of the loan with compound interest charges, use the following equation: P { [1 + ( r / n ) ] ^ nt}
The variables stand for:
P = Principal
r = Annual interest rate as a decimal
n = Number of times interest is compounded each year
t = Loan term in years
Based on the above data for our loan, the equation would look like this: $50,000 {[1 + (.1/12)]^12x1}
That means the total loan repayment amount would be $55,235.65, with the interest portion equaling $5,235.65.
Don’t worry, if all that math makes your eyes glaze over, you can use an online compound interest calculator instead.
Bonus tip: For a loan with simple interest, use this formula to find out how much interest you’ll pay: P x r x t.
For a $50,000 loan with 10% simple interest and a one-year term, the interest would be $5,000, and the total cost would be $55,000.
You can use an online simple interest calculator as well.
MCA Cost Example
Now let’s look at the MCA. To calculate the total cost of the financing, we’ll multiply $50,000 by 1.3.
That means the total repayment amount would be $65,000, with the factor rate portion equaling $15,000.
You can see in this example how even with compounding interest, the term loan is more affordable than the MCA. You’d need a low factor rate of 1.1 for the MCA to cost less than the term loan with compound interest.
Even with a lower factor rate, don’t forget to consider the repayment period. The MCA would be paid back within six months instead of 12 months for the short-term loan, which might be a strain on your cash flow.
Factor Rate FAQs
Here are answers to some additional factor rate questions you might have.
What Types of Business Financing Products Use Factor Rates?
Typically, you see factor rates with certain short-term financing products. They’re most prevalent with merchant cash advances (MCAs).
With MCAs, you borrow against future debit and credit card sales, receiving an advance amount upfront. The MCA provider then charges a factor rate to determine your total repayment amount.
This type of financing is commonly used by startups or businesses with bad credit that struggle to get approved for small business loans and other funding options. The downside is, merchant cash advances often lead to a buildup of debt.
What Determines the Factor Rate You Receive?
Similar to an interest rate, a borrower might receive a lower or higher factor rate based on their funding amount, credit history, or credit score.
Look for Flexible Funding With Competitive Rates
Factor rates look simple and straightforward, but when you translate them into APRs, you see how high the costs are compared to interest-based financing options. So before you choose to go with a factor-rate-based MCA, consider flexible funding alternatives.
Backd provides lending products that give small businesses the working capital they need to meet goals, harness opportunities, and ride the waves of seasonality:
Business Term Loan*: Available in loan amounts up to $1.5 million and terms extending up to 24 months
Business Line of Credit: Available in amounts up to $1 million and terms up to 12 months
Apply now** and receive a funding offer within as little as 6 hours.***
*Loans are decisioned and funded by one of Backd's lender partner banks.
**Your application, including the amount, cost, and approval, is subject to review and is not guaranteed. Terms and conditions subject to change without prior disclosure or notice.
***Decisions and funding may take additional time and not be same-day. Additional information may be required. Time to receive funds varies based upon your financial institution's receiving schedule and operating hours.
