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Financial terminology and small business lending options can be tricky to understand, sometimes by design. When you factor in all of the different funding options, each with their own unique fees, cost structures, and rates, understanding and comparing them can be difficult.
There are two common types of rate structures used in small business lending: interest rates and factor rates. If you’re seeking funding for your business, it’s integral that you understand the cost of your loan or advance before you sign a contract—after all, you have to know what you’re agreeing to in order to make the right choice for yourself and your business.
This means knowing what an interest rate is and what a factor rate is, what the difference is between them, and how it impacts your terms.
Let’s explore these two types of rates:
Most funding options, including SBA loans, term loans, and other traditional forms of financing use an interest rate or “annual percentage rate” (APR) to represent the total cost of your loan.
Other types of funding, including alternative funding options like merchant cash advances (MCAs) or invoice factoring, use something called a factor rate. This may be the first time you have heard of factor rates and they may seem confusing, but they are surprisingly simple. We’ll explain how they work and how to calculate them below, but first let’s take a quick refresher on interest rates.
An interest rate is the percentage of principal (i.e. total money loaned) charged by your lender to borrow money. It’s applied to your remaining balance each month and compounds (i.e. you are charged interest on your interest) as you pay off your loan.
The total interest accrued over the life of your loan varies depending on your term length, whether you miss payments, and which type of interest rate is applied to your loan, such as fixed or variable interest.
Like interest rates, factor rates also represent the cost of your funding. However, unlike an interest rate, factor rates are expressed as a decimal number and apply only to the original amount borrowed, meaning that your factor rate is built into your payment schedule and doesn’t compound monthly the way an interest rate does. Most factor rates fall between 1.1 and 1.5.
Factor rates are used exclusively for business funding and are most often applied to merchant cash advances and other forms of alternative small business funding.
Factor rates depend on a number of elements, including:
To calculate the cost of your funding using a factor rate, multiply the loan amount by your factor rate. For example, on an advance of $10,000 with a factor rate of 1.3, you will owe $13,000.
When considering multiple types of funding, calculating how much each funding option will cost can help you understand your options and make the right decision for your business. Here’s how to convert a factor rate to APR so you can easily compare:
1. Calculate the total payback amount
Advance amount x factor rate = total payback amount
$10,000 x 1.3 = $13,000
2. Calculate the total cost of your advance
Total payback amount – advance amount = cost of advance
$13,000 – $10,000 = $3,000
3. Calculate the percentage cost
Cost of advance / advance amount = percentage cost
$3,000 / $10,000 = 0.3
4. Calculate annualized interest rate
Percentage cost x 365 (days in a year) = X
0.3 x 365 = 109.5
X / expected repayment period (in days—you may have to estimate here) x 100 = annualized interest rate
109.5 / 90 days x 100 = 121% annualized interest rate
It’s important to note that when you convert a factor rate into an annualized interest rate, it may appear higher than the interest rates offered by banks at first glance. However, your total loan costs may actually not be that much higher if you opt for a funding option that uses a factor rate.
Interest rates compound as you pay off your loan and can add up to a significant amount over the term of your loan, especially if:
Factor rates, on the other hand, are typically used for lending products that have no fixed term, which means:
| Factor Rate |
Interest Rate |
|---|---|
| Expressed as a decimal figure (eg. 1.3) |
Expressed as a percentage (eg. 5.25%) |
| Applies to original funding amount |
Applies to remaining balance and compounds as you pay off your loan |
| Used for merchant cash advances and other forms of short-term or alternative funding |
Used for term loans, lines of credit, and credit cards, as well as personal lending products |
The truth is that one rate isn’t necessarily better than the other. The rate that is better for you ultimately depends on your business and the reason(s) you need funding.
Funding options that utilize factor rates, such as MCAs and other alternative forms of funding, offer a number of advantages over financing from traditional lending institutions, including:
