By Sam Osterling
Sam Osterling is a communications analyst and freelance writer based out of Long Island. He writes about small businesses, finance, marketing, and more.
Every time you apply for financing or to borrow money, you’ll notice an associated interest rate or factor rate. But what are the differences between these two rates and why does it matter for business owners? These numbers will look wildly different, but at their most basic level, factor rates and interest rates are both numerical signifiers of how much you’re going to pay in order to borrow money.
Maybe the best way to understand what makes these rate signifiers different is to understand them each individually. We’re going to break it all down for you and explain what makes factor rates and interest rates different and why every business owner should care.
What are Factor Rates?
Factor rates are most commonly used in the process of acquiring short-term financing like a merchant cash advance, also known as a business cash advance. In a merchant cash advance, a financial institution gives a business money up-front which is repaid automatically by deducting a certain amount of money from the business’s future sales, like incoming credit or debit card payments, until the advance is repaid.
And how much is repaid? That’s where factor rates come into play. Expressed as a decimal, usually, somewhere between 1.1 and 1.5, a factor rate is multiplied by the principal amount, which results in the total repayment amount.
If you receive a merchant cash advance of $12,000 with a factor rate of 1.25, you’ll repay $15,000 – a total of $3,000 more than you borrowed.
If the financing you’re looking at includes a factor rate, chances are it’ll be quicker or easier to obtain. Cash advances can be approved quickly since they’re specifically designed to help businesses cover short-term needs. They can also be given to borrowers with poor credit, and they’re very flexible – the funds can be used for almost any kind of business purpose.
For those reasons, advances with factor rates are favored by business owners who want to get things done quickly and efficiently to help their companies grow. If an emergency or crisis pops up, it’s good to know that there are options you can turn to where you’ll be able to get money as fast as merchant cash advance providers do, so how’s that different from an interest rate?
What are Interest Rates?
Interest rates are the most common way of signifying how much a borrower will pay to borrow money. You’ve probably heard lots of talk about interest rates on the business news channels – that’s because it’s how most loans are priced, both for commercial and personal purposes.
Methods of charging interest are all over the map and get incredibly complicated. However, the most common method involves charging interest based on a set percentage of the remaining principal at defined, regular intervals.
What does that mean in practice? Suppose you borrow the same $12,000 as you did above, but the lender charges 6% interest to be compounded monthly. At the end of the first month, your new balance will be $12,720. If, the next month, you make a $2,000 payment, your balance will be $10,720. And the next interest calculation will be based on that new balance.
Many types of small business loans include an interest rate. Small Business Administration (SBA) loans, commercial real estate loans, equipment loans, business lines of credit, and business credit cards can all carry an interest rate, to name a few.
Since loans with interest rates tend to require repayment over a defined term, calculating your business loan repayments is often a good idea before you agree to take the money. Depending on the term of your loan, you could find that your monthly payments will be smaller or larger than other financing options.
If given the choice, most business owners would favor a loan that includes an interest rate over one that features a factor rate. The reason for that choice is deceptively simple.
What’s the difference?
If asked about their preferences, most business owners say they would prefer a loan that includes an interest rate over one that features a factor rate. But that choice is a little deceptively simple.
The total repayment amount for financing with a factor rate is calculated in advance based on the original funding amount; however, the total repayment amount for loans with interest rates will change depending on how quickly repayment is made. It’s a deceptively simple difference, but it’s incredibly important.
Because interest is calculated based on the amount of remaining principal throughout the life of the loan, aggressive repayment is rewarded by paying less in interest. Because repaying factor rate-calculated advances is done ahead of time, an ability to pay back the full amount may not reduce the total amount owed. In the above example, that $3,000 you’ll repay on top of the principal will only ever be $3,000. However, for an interest rate bearing loan, if you find yourself unable to meet the schedule of monthly payments that have been pre-determined, the interest charges that have already been racked up will be included in the next charge that’s applied. In effect, if you miss a payment or can only make a partial payment one month, you could end up getting charged a whole lot more than you expect. Your expected $3,000 payment could become $3,500 or $4,000 if you fall behind on your payments.
What’s the takeaway?
No matter how you borrow money, you’ll have to pay for it. Paying a factor rate vs. paying an interest rate is often no more than an indicator of the type of loan you’ve chosen and been approved for, and that’s what you should keep in mind.
Loans with interest rates usually take longer to get approved. The application process is typically more complicated and will require a higher level of financial and business scrutiny than financing like merchant cash advances that come with factor rates.
In addition, repayment of an advance with a factor rate is usually done in one of two ways: as a percentage of card sales in a given time frame, or in regular payments of an agreed-upon size. Payment by percentage can be a real advantage for business owners. If you have a down week, you won’t have to pay as much. With an interest rate on your loan, if you have a down week you can run into financial issues which may require further loans – and send your business into a costly debt cycle.
So if you’re confident in your ability to repay a loan quickly – and you’re not worried about having slowdowns in sales – the best business loan for you might require taking the time to go through the necessary run around to get a longer-term loan. It can be a good idea to work with a financing partner you trust to help you gather all the required paperwork and process your loan application as quickly as possible.
There are also lots of situations where a cash advance or factor rate product is your best option. This financing isn’t just for those times when a vital, expensive piece of equipment breaks just before your busiest season begins. When properly understood, choosing a factor rate product is actually a great way to stay in control of your funding costs.
The biggest thing to remember is that no matter the type of financing you choose, all borrowing carries a price. No matter if it’s calculated in interest rates or factor rates, knowing how much you’ll have to pay to get access to funds up-front is always your best bet as a business owner.