Factor Rate vs. Interest Rate: Understanding Small Business Loan Rates and Fees
March 3, 2023
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Factor rate and interest rate are both methods for calculating the cost of financing, but they are calculated differently and have distinct characteristics. In the world of small business financing, companies providing funding make money in one of two ways: charging factor rates or charging interest rates.
Factor rates offer simplicity and accessibility for business owners with poor credit scores, while interest rates typically provide lower fees and greater predictability for businesses with better credit scores.
But which one is the better choice for your business?
What are Factor Rates?
A factor rate is a decimal that represents the total cost of borrowing, including interest and fees, as a multiple of the original loan amount. Factor rates are one aspect of many financing options where a lender provides a business with a lump sum of capital, and then charges a fixed fee based on the amount borrowed. The fee is expressed as a decimal figure (usually ranging from 1.1 to 1.5) that is multiplied by the amount borrowed to calculate the total amount the borrower will need to repay.
Financing involving factor rates is often used as an alternative to traditional loans and business lines of credit, and is typically sought by businesses looking for short-term financing or have poor credit scores. Merchant cash advances (MCAs) commonly charge factor rates, for example. It should be noted that MCAs are not loan products, which is one reason they use factor rates and not interest rates.
Calculating total repayment using a factor rate is straightforward. The factor rate is a decimal figure that is typically expressed to two decimal places, such as 1.20 or 1.35. To calculate the total repayment amount, simply multiply the factor rate by the amount borrowed. For example, if a business borrows $10,000 and the factor rate is 1.30, the total repayment amount would be $13,000 ($10,000 x 1.30 = $13,000).
Advantages of factor rates
There are several advantages to using factor rates, and the forms of business funding that use them, as your primary financing option, including:
Simplicity and ease of use: Factor rates are straightforward and easy to understand. Borrowers know exactly how much they will be required to repay, and there are no compounding interest charges or complex calculations to worry about. On top of that, repayment is typically done using a fixed percentage of each day’s debit and credit card sales, so repayment is simple too.
Available to businesses with poor credit scores: Since factor rates are determined based on the lender’s assessment of the borrower’s creditworthiness and business performance, they are often more accessible than bank loans to businesses with poor credit scores. Less expensive types of loans, like SBA loans, often require years of business history and great credit. Not every business meets those requirements, and the cash advances that use factor rates can be a great option.
Quick access to funds: Financing with factor rates is often used for short-term needs, such as unexpected expenses or temporary cash flow shortages. Since the approval process is usually quick and straightforward, borrowers can often access the funds they need in a matter of days. Some MCAs, like those offered by The LCF Group, can be in your bank account by the very next business day.
No collateral required: Unlike traditional loans, funding with factor rates typically doesn’t require collateral. This means that borrowers don’t need to put their assets at risk to secure the financing they need.
Flexibility: Factor rates can be used for a wide range of business purposes, from purchasing inventory to working capital to funding marketing campaigns. This flexibility makes them a useful financing option for businesses of all sizes and types.
On the other hand, an interest rate is the cost of borrowing money as a percentage of the loan amount per year. It is usually expressed as an annual percentage rate (APR) and takes into account the duration of the loan. Interest rates for business loans are the percentage of the total loan amount that a lender charges the borrower for the use of the funds. Essentially, it is the cost of borrowing money from a lender.
Interest rates are typically expressed as an annual percentage rate, and can vary depending on a number of factors, such as the borrower’s credit score, the purpose of the loan, the term of the loan, and the lender’s risk assessment of the borrower’s ability to repay the loan.
Business loans with lower interest rates are usually reserved for businesses with good credit scores, while higher interest rates are typically offered to businesses with lower credit scores or higher perceived risk.
Unlike factor rates, interest rates are usually calculated on a monthly or daily basis, and the total repayment amount will vary depending on the length of the loan term and any additional fees or charges. If you pay off a loan quickly, you’ll pay less in interest. Not so with business financing that uses a factor rate.
The calculation of business loan interest rates can vary depending on the specific terms of the loan. However, interest is typically calculated as a percentage of the outstanding loan balance that is due on a regular basis (usually monthly). To calculate the amount of interest owed for a given period, you can use the following formula:
Interest = (Remaining Loan Balance x Interest Rate x Time Period) / 12
Outstanding Loan Balance is the amount of the loan that remains unpaid.
Interest Rate is the percentage rate at which interest is charged, expressed as an annual percentage rate (APR).
Time Period is the length of time (in months) for which interest is being calculated.
For example, if a business borrows $100,000 at an interest rate of 6% per year for a loan term of 24 months, the interest calculation for the first month would be:
Interest = ($100,000 x 6% x 1) / 12 Interest = $500
This means that for the first month of the loan, the business would owe $500 in interest. The total repayment amount would be the sum of the interest and the principal (i.e., the amount borrowed).
Advantages of Interest Rates
There are several advantages to using one of the types of business loans that use interest rates, as opposed to a factor rate. These include:
Lower total cost of borrowing: In many cases, interest rates may result in a lower total cost of borrowing over the life of the loan, especially for longer-term loans. This is because interest rates typically have lower rates compared to factor rates, and the interest is calculated based on the outstanding loan balance, which decreases as the loan is repaid. Paying back a loan quickly results in paying less in total interest. When a factor rate is used, you pay the same total amount back whether it takes two months or two years.
More suitable for long-term financing: Interest rates are often a better option for long-term financing needs, like real estate purchases or equipment financing. Since the interest rate is calculated based on the outstanding loan balance, borrowers who need to borrow money for a longer period of time can benefit from a lower interest rate and lower overall borrowing costs.
Builds credit score: Using a loan with an interest rate and making on-time payments can help build a business’s credit score. This can be beneficial in the future, as it can improve a business’s chances of obtaining financing at more favorable terms. Many types of financing that use a factor rate aren’t legally considered loans. While that has its benefits, it also means that repaying an advance amount, for example, won’t boost your credit.
Factor Rates vs. Interest Rates: Which is Right?
Funding options that use factor rates (like merchant cash advances) and interest rates (like short-term loans) can be appropriate in different business situations depending on the business’s needs, goals, and financial situation. Here are some examples of when one financing option may be better than the other:
You Might Consider Funding with Factor Rates:
When a business needs short-term financing to cover cash flow shortages or unexpected expenses may benefit from a factor rate. Since factor rates are typically used for short-term financing, businesses that need to borrow money for a few months can benefit from the short application process, overall simplicity, and ease of use.
Businesses that have a poor credit history or limited credit options may also benefit from financing that uses a factor rate, as they may be easier to obtain than traditional loans.
Businesses that need to purchase inventory and equipment, or have other operational costs that don’t require a long-term repayment plan can use a factor rate to get quick access to cash.
You Might Consider Funding with Interest Rates:
Businesses that require long-term financing, like mortgages or large capital expenditures, may benefit from loan options with interest rates. They usually have longer repayment terms, so businesses can spread the cost of the loan over a longer period, resulting in a more manageable repayment schedule.
Businesses that have good credit scores and a strong financial history can often obtain lower interest rates, which can result in lower overall borrowing costs.
Businesses that are looking to establish or improve their credit history can benefit from an interest-rate loan. Making on-time payments can help build a business’s credit score.
Businesses that need a more flexible repayment schedule can benefit from an interest-rate loan, which may offer more options for customizing the loan repayment terms, such as monthly payments, balloon payments, or interest-only payments.
Ultimately, the choice between a factor rate and an interest rate will depend on the business’s necessary funding amount, financial situation, and goals. It’s important to carefully consider the options and choose the financing option that best meets the business’s needs.