A factor rate expresses the percentage of a loan amount that you need to pay back. It’s commonly used in commercial financing offers (such as sales- or revenue-based financing) and merchant cash advances. Factor rates are typically expressed as a decimal figure between 1.1 and 1.7.
Below, you’ll learn more about what a factor rate is, how it operates, and how nonbank finance companies typically use factor rates to make money.
Key Points
• Factor rates are charged by lenders on certain types of loan products instead of using a traditional interest rate. It’s expressed as a decimal as opposed to a percentage.
• To calculate the total cost of your loan, simply multiply the loan amount by the factor rate. Add in any additional fees the lender may charge.
• Pros of factor rates include fast funding times, less stringent credit requirements, and it’s relatively easy to determine the total cost of the loan.
• The main con of factor rates is they typically are a very expensive form of borrowing, and can translate into APRs of 70% or more.
Factor Rates Defined
Factor rates are typically used by nonbank finance companies to calculate some or all of your total costs on nontraditional commercial funding.
A factor rate is typically used in the following sales-based financing or revenue-based financing products:
• Inventory financing
• Invoice factoring
• Merchant cash advance (MCA)
• Purchase order financing
Factor rates on a merchant cash advance typically range from 1.1 to 1.7, and the rate is used to calculate your repayment costs (not including any additional fees).
Factor Rates vs APR
It’s worth noting that MCAs and other sales-based financing products are typically expensive when compared with traditional small business loans. That’s because the total costs of a merchant cash advance can include a factor rate and additional fees that would typically represent a high annual percentage rate (APR) if it were a traditional bank loan.
With a merchant cash advance, reports indicate that you can wind up with an APR of close to or even more than 100%.
The APR on a small business microloan, meanwhile, can have APRs starting at 7% or 8%. Community-based microlenders may offer microloans of up to $50K.
Recommended: What Is Trade Working Capital?
How Do You Calculate a Factor Rate?
To calculate the total cost of the loan with a factor rate, simply multiply the loan amount by the factor rate.
Here’s an example of a factor rate in action: Say a business owner takes out a merchant cash advance (MCA) for $10,000 and the factor rate is 1.2.
$10,000 x 1.2 = $12,000
So $12,000 is the total amount of money owed on the merchant cash advance if the provider doesn’t charge additional fees. Some MCA providers may charge additional fees on top of the factor rate.
An MCA is a common type of sales-based financing that charges a factor rate vs. a short-term business loan that charges interest.
What Lenders Look at To Determine a Factor Rate
As with a lender who issues interest rate loans, a lender who offers sales-based financing with a factor rate generally also wants to know that borrowers will be able to pay the financing back. Even though taking payments directly from a merchant’s sales provides some security to the lender, if a borrower is perceived as more risky, it might be offered a higher factor rate.
Every lender has its own requirements, of course. But across the board, in order to determine your factor rate, a lender may ask to see:
• Credit card processing statements. The lender will want to see proof that you have credit card sales large enough for it to deduct payments from them.
• Bank statements. A lender may want a sense of your business’s financial situation and request some of your recent bank statements.
• Time in business. Typically, lenders prefer to lend to businesses that have been operating for at least a year.
• Business tax return. This will allow the lender to assess the financial health of your business.
Lenders may consider other factors when determining your factor rate, but these are among the most likely components.
Factor Rate vs Interest Rates
Although it’s similar in some ways, a factor rate is not the same thing as an interest rate. As mentioned earlier, a factor rate is a percentage of a commercial financing offer, and the rate is typically expressed as a decimal figure between 1.1 and 1.7. Sales-based financers, including merchant cash advance providers, can make money by charging a factor rate.
Factor rate example: A $10,000 MCA with a 1.2 factor rate would cost at least $12,000. The factor rate doesn’t necessarily tell you the total cost of the MCA, because MCA providers can charge additional fees on top of the factor rate.
An interest rate is a finance charge typically expressed as an annual percentage of a borrower’s outstanding principal. State usury laws can limit the maximum interest rate that lenders charge on traditional loan products. You can typically minimize your total interest charges by paying a loan off early.
Interest rate example: A $10,000 microloan with a 7% interest rate, five-year repayment plan, and no additional fees would cost about $11,880 after 60 months. The total borrowing costs would be lower if there’s no prepayment penalty and you pay the loan off early.
Here are some points to keep in mind:
• The interest rate doesn’t necessarily tell you the total cost of a loan, because lenders can charge additional fees on top of the interest rate charges.
• A merchant cash advance is a sales-based financing solution that typically charges a factor rate, whereas traditional loans typically charge interest.
• APR takes the interest rate and upfront fees into account, so APR can give you a better idea of a loan’s total cost than the interest rate alone.
Recommended: Guide to Variable Costing Income Statements
Pros and Cons of Factor Rates
Here are some pros and cons of factor rates:
Pros of Factor Rates
• Relatively easy to calculate costs upfront
• Factor rate products, such as merchant cash advances, typically have fast funding times
• Factor rate products may have less rigorous credit score requirements than other forms of financing
Cons of Factor Rates
• Factor rate charges cannot be minimized via prepayment
• Factor rates are a nontraditional commercial financing term
• Can translate into APRs of 70% or higher
Recommended: What Is the Minimum Credit Score for a Business Loan?
The Takeaway
A factor rate is the percentage of the loan amount that a borrower must pay to pay back a loan, expressed as a decimal. It’s a nontraditional financing term typically used by merchant cash advance providers. Nonbank finance companies may charge a factor rate along with additional fees.
Typically, loans that come with factor rates end up being more expensive than traditional small business loans.
If you’re seeking financing for your business, SoFi can help. On SoFi’s marketplace, you can shop top providers today to access the capital you need. Find a personalized business financing option today in minutes.
FAQ
What is a factor rate?
A factor rate is a fee structure used in merchant cash advances and some short-term business loans. It’s expressed as a decimal, such as 1.2 or 1.4, rather than a percentage and determines the total repayment amount.
How is a factor rate calculated?
To calculate the total repayment, multiply the loan amount by the factor rate. For instance, a $10,000 loan with a factor rate of 1.2 would require repayment of $12,000. Factor rates do not accrue over time, and the total repayment amount is fixed from the start, making it easier to understand the full cost of borrowing.
How do factor rates work?
Factor rates are fees that lenders charge for certain types of business loans, mainly merchant cash advances. They are expressed as a decimal rather than a percentage, and are multiplied by the total loan amount. If you have a loan for $10,000, for example, and a factor rate of 1.3, you would multiply those two numbers together for a total of $13,000. The factor rate calculates a flat fee and it does not grow over time.
Photo credit: iStock/FG Trade Latin
SoFi's marketplace is owned and operated by SoFi Lending Corp. See SoFi Lending Corp. licensing information below. Advertising Disclosures: SoFi receives compensation in the event you obtain a loan through SoFi’s marketplace. This affects whether a product or service is featured on this site and could affect the order of presentation. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.
SOSMB-Q324-005