Factor Rate vs. Interest Rate: Understanding Small Business Loan Rates and Fees

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:

Who uses interest rates and who uses factor 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.

What is an interest rate?


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.

What is APR? APR isn’t quite the same as a simple interest rate. APR is the total cost of your loan expressed as a percentage, including interest and any additional fees that may be incurred over its entire lifetime.

What is a factor rate?


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:

  • Stability of sales and growth: Your sales and growth indicate your ability to repay your merchant cash advance to your lender. Stable sales and consistent growth may result in a lower factor rate.
  • Your industry: Certain industries carry more risk for lenders than others. Businesses in these fields, such as seasonal businesses, may have a higher factor rate to reflect that risk.
  • Average monthly credit card sales: MCAs are repaid as a percentage of your daily or weekly credit and debit card sales. Your monthly sales average shows how likely you are to be able to repay your advance, so with consistently high monthly sales, your rate should be lower.
  • Your length of time in business: The longer you’ve been in business, the lower your factor rate will be. But don’t worry if you’re a newer business—most MCA lenders only require you to be in business for a minimum of six months to qualify (versus 2+ years for traditional lenders and term loans).
  • Risk assessment and creditworthiness: Your business’s financial history and credit rating won’t factor into your approval as heavily as they would with a traditional lender, but these criteria can impact your factor rate. Businesses with low credit scores are often able to qualify for alternative funding, but they may have a higher factor rate.

How to Calculate Factor Rate: Factor Rate Formula


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.

Funding amount x factor rate = total payback amount

How To Convert Factor Rate to APR


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

Are Factor Rates Always Higher Than Interest Rates?


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:

  • You have a fixed term*
  • You have a large loan
  • You’ve missed payments
  • Prime lending rates change

*Some loan terms, like fixed term loans, stipulate that you can’t repay your funding faster or in larger amounts than your fixed term length schedule without being subject to penalties and additional fees.

Factor rates, on the other hand, are typically used for lending products that have no fixed term, which means:

  • You can pay them back in your own time
  • Your cost of funding will not change
  • You will not be charged additional fees or penalties for paying back funding earlier than expected

Factor Rate vs. Interest Rate Comparison Chart


   
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

Factor Rate or Interest Rate: What’s Better?


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.

Financing with a factor rate is best for:
Financing with an interest rate is best for:
  • Businesses who need larger loans with longer terms
  • Businesses in operation for 2+ years
  • Businesses with strong credit histories
  • Businesses that don’t need funding quickly and have time to navigate the longer application process of the SBA and other commercial lenders
  • Businesses who need fast funding
  • Businesses who need smaller loan amounts with shorter terms
  • Businesses with lower credit scores
  • Younger businesses
  • Businesses that don’t have collateral

Is Alternative Funding Right For You?


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:

  • Simple applications, less paperwork, and less rigorous approval requirements.
  • A variety of funding types, with funding from as little as $3,000 up to $500,000.
  • Greater flexibility and more room to negotiate terms
  • Faster processing and approvals

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Alfredo Rosing

Alfredo Rosing is the Vice President of Marketing at Greenbox Capital®. With over 25 years of combined experience in marketing and financial services, Alfredo is an expert on innovative financial technologies with a passion for connecting consumers and businesses with socially responsible funding. Prior to joining the Greenbox Capital team, Alfredo launched an award-winning online lender that was recognized as the winner of the 2017 Fintech Awards US Firm of the Year for Lending Innovation Award. Alfredo is a graduate of Southern New Hampshire University with a BS in Marketing.

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