If you’ve ever owned a credit card, vehicle, or house, you probably understand the concept of an interest rate. In its simplest form, this metric identifies how much money you will owe on an unpaid balance. Interest rates are always expressed in percentages, making it easy to grab a calculator and figure out how much you would owe in any given scenario.
But what does “factor” mean? This metric also relates to how much you’ll owe for borrowed money, but there are some crucial differences. For example, unlike an interest rate, factor rates are expressed in decimal figures.
“With invoice factoring, the interest and fees are not represented as an interest rate or APR,” explains financial expert Andrew DePietro. “This is because the borrowing rate is a factor rate, which means, rather than being denoted in percentages, it is described in terms like 1.2 or 1.5 factor rate. What this is really saying is that the borrowing rate is not 1.2% or 1.5%, but 120% or 150%.”
While popular small business financing options like startup loans and equipment financing come with interest rates, a small family of financing products uses factor rates. These can include merchant cash advances and short term loans. The factor payment rate you qualify for will depend on details such as your business tenure, what industry you work in, your annual revenue, and the trajectory of your sales.
Factor rates may not be as commonly used in the market, but they’re not difficult to decipher. To calculate how much money you will need to repay on a loan, you simply multiply the amount you’re hoping to borrow by the factor rate. For example, if you were going to borrow $100,000 and the factor rate was 1.18 for a 12-month term, the amount to be repaid would be $118,000.
Interest Payments vs. Factor Payments
With an interest rate, your payments actually have a moving target because the rate will be recalculated over the course of your financing, based on the depreciating capital.
Conversely, factor rates are calculated up front and never change. Rather than make recurring payments as you would with a standard loan, you’ll pay the full amount up front.
It’s also important to note that the numerical nature of factor rates can be misleading. For example, if you saw a factor rate of 1.3, you might not think that sounded particularly high. But that rate would be comparable to an interest rate of 130%. So you need to reset your baseline when dealing with factor payments.
When to Use Short Term Financing with Factor Rates
This type of financing is engineered for speed, rather than long-term usage. And you’ll pay for that expediency via lower principal amounts, higher rates, and shorter repayment periods. What you get in return is a smoother application process, more lenient qualification standards, and faster funding.
Financing with factor rates can be ideal for situations such as:
- Business emergencies
- Seasonal slumps
- Sudden inventory needs
- Equipment repair
- New business opportunities
You’ll always need to weigh the costs and limitations carefully before pulling the trigger. In some cases, this financing is the best way to get a critical influx of money. Other times, it is too limited to provide the sustained impact you might need.
At the Head of the Factor Rate Pack
Of all the financing that uses factor rates, merchant cash advances are among the most popular. You can borrow as much as $200,000, and the money can become available within 24 hours of your approval by a lender.
With a merchant cash advance, you base the financing off future earnings. So a lender may check your credit score, but they won’t do a deep dive into your financial history. They’ll be more interested in how your business has done the past few months and where it’s projected to go.
“Using a merchant cash advance to get funding is a great route when you need the money immediately,” says Forbes. “It’s a solid solution for when your business has contracts it’s working on but is in need of cash right now. The promise of work and future payment in your business contracts can be used to get funding via a merchant cash advance.”
Getting All the Financing Facts
With all this focus on factor rates and other pricing metrics, it’s important to note that some lenders list these metrics inconsistently. Other times, they’ll hide sketchy fees in their disclosures. For this reason, it’s essential for you to do your due diligence before submitting any applications.
“You may feel like you have time against you, but it’s okay to slow down a bit,” insists Business.com. “The absolute worst thing you can do is rush into this. Prematurely selecting a loan, only to figure out a month from now that you chose the wrong one, can be devastating to your business. Be patient and carefully evaluate all of your options before proceeding too far in the process.”
There are plenty of online resources to help you with this process. Start with a basic loan calculator to break down the numbers into comparable sets. But what if the numbers have been listed inconsistently, making such comparisons difficult?
This situation is where a more robust tool, such as SMART Box™ (Straightforward Metrics Around Rate and Total cost), becomes helpful. Created by some of the industry’s brightest minds, SMART Box™ allows you to find a common language between loans and interpret confusing disclosure standards.
There’s a version of SMART Box™ customized to merchant cash advances, giving you a powerful way to cut through the ambiguity and make a more educated decision. Whether you use a calculator, SMART Box™, or simply talk to a lending expert 1-on-1, the objective is to gain as many insights as you can, setting yourself up for a better decision.