When considering your small business financing options, you’ll want to determine the associated costs of every alternative. Although this may seem straight forward, pricing is often presented differently depending on the company or the type of financing product you are applying for. This can make it tricky to understand how much you are actually paying for your loan, and therefore difficult to evaluate your options. This is a common problem, so to help, here’s a comparison of the rates most commonly used by business lenders: interest rates and factor rates.
What is an interest rate?
An interest rate is a percentage that represents how much a borrower pays a lender for the use of funds. The final cost of financing after interest has been added is only known at the end, as it can vary depending on the length of time it takes for you to pay back your loan. If you miss a payment, interest will compound and if you payback early, you could save on interest. When it comes to small business lending, interest is generally associated with term loans and lines of credit:
With a term loan, you receive a fixed amount of funds in a lump sum to be repaid in a prearranged schedule of payments over a defined term. Payments commonly combine an amortization of the debt, meaning that each loan payment you make covers a portion of interest on the loan along with a portion of the principal loan balance.
With a business line of credit, you receive access to a stated amount of funds that can be used as needed and your payment is based upon the funds you use. Interest works in the same way as with a term loan; however, you only pay interest for the funds you use as you use them.
Pros of an interest rate
- The cost of borrowing is generally lower than with a factor-based product
- You can benefit from decreased costs with early repayment
Cons of an interest rate
- Additional costs will be incurred if you are unable to make your scheduled payments
- The final cost of borrowing is less predictable than with a factor rate
Calculating the total cost of financing with an interest rate
Assuming the predetermined payment schedule is followed, calculating this number is easy. For example, to calculate the cost of borrowing on a 12-month, $50,000 loan with a 20% interest rate:
Amount borrowed x Interest Rate = Cost of financing
50,000$ x 20% = 10,000$
Is an interest rate right for my business?
Although interest based financing products generally have a lower cost of borrowing, they do involve a level risk. You don’t want to find yourself racking up interest charges because you are unable to make your scheduled payments. Businesses who could benefit from this type of financing generally:
- Can budget to follow their payment schedule (believe they can make their payments on time)
- Have a more established credit score
- Are attracted to the early payback incentive
What is a factor rate?
A factor rate also represents the amount charged for borrowing funds, however it is expressed as a decimal figure, rather than a percentage. Unlike interest rates, it only applies to the original amount borrowed and the cost of borrowing does not change. Therefore, the total amount repaid for financing with a factor rate is fixed and can be calculated from the very beginning.
Factor rates are primarily used to illustrate the cost of funding with merchant cash advances (MCA). An MCA is when a business essentially agrees to sell a portion of their future card sales at a discount to a lender. Repayment amount and term are flexible because repayment is based on a percentage of those daily card sales until the advance is paid off.
Pros of a factor rate
- Your final cost of lending is fixed and known upfront
- There is no fixed term in which you have to repay the funds; you pay back in your own time
- Your cost of funding will not increase if you take longer to payback than expected
Cons of a factor rate
- The cost of borrowing is generally greater than with interest-based financing options
- Your cost of financing does not decrease if you pay back earlier than expected
Calculating the total cost of financing
To determing how much you will have to payback with a factor rate is straightforward; you simply multiply the factor by the amount borrowed. For example, to determine the total cost of a $50,000 cash advance with a 1.25 factor rate:
Factor rate x Amount borrowed = Total payback
1.25 x $50,000 = $62,500
Total payback – Amount borrowed = Cost of financing
$62,500 – $50,000 = $12,500
Is a factor rate right for my business?
Because factor based financing products are repaid automatically through a portion of a business’s future sales, lenders generally rely more heavily on a business’ revenue flow, than their credit score for approval. Also, because of its predictability and flexibility (the cost of borrowing is determined at the beginning and there is no set timeframe for repayement), factor based financing is a great option for businesses who:
- Have a less established credit score
- Process a large number of card sales
- Like the ideal of knowing how much they are paying upfront
- Are seasonal (can pay back faster when sales are strong, and benefit from smaller payments when they’re not)
By understanding the difference between factor and interest rates and how they are calculated, you are well-equipped to properly compare your financing options. Armed with this knowledge, you can confidently find the lending option that best suits you and your small business’ unique needs.