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

When you apply for small business funding, it’s important to understand the cost of your loan or advance before you sign a contract. But because different funding options come with different fee and cost structures, comparing your options and understanding the total cost of your funding can be a challenge.

Many funding options, including Canada Small Business Financing Program 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 or invoice factoring, use something called a factor rate. Factor rates may seem confusing, but they are actually quite simple. We’ll explain how they work and how to calculate them below.

Most of us are familiar with the concept of an interest rate, but let’s take a moment to review what interest rates are before we dig into factor rates.

An interest rate is the percentage of principal charged by your lender to represent the total cost of borrowing. It’s applied to your remaining balance each month and compounds as you pay off your loan. The total interest accrued over the life of your loan will vary depending on your term length and whether you miss payments or are able to accelerate your payment schedule.

Interest rates are not the same thing as APR. APR reflects the total cost of your loan as a percentage, including interest and any additional fees that may apply. Interest is simply the cost of borrowing, and does not include any other fees.

Factor rates, like interest rates, represent the cost of your funding. However, instead of being expressed as a percentage, factor rates are expressed as a decimal number. Most factor rates fall between 1.1 and 1.5.

Unlike interest rates, factor rates apply only to the original amount borrowed. Your factor rate is built into your payment schedule, and the cost of borrowing does not compound or change as you pay off your funding.

Factor rates are most often applied to merchant cash advances (MCAs) and other forms of alternative small business funding. They are specifically used for business funding, while interest rates and APR can also apply to personal loans.

Factor rates depend on a number of factors, including:

• Your industry: Some industries carry more risk than others, such as seasonal industries or industries in decline. Businesses in these fields may have a higher factor rate.
• Your length of time in business: MCA lenders require you to be in business for a minimum of six months to qualify (compared to 2+ years for traditional lenders and term loans). The longer you’ve been in business, the lower your factor rate will be.
• Stability of sales and growth: Your sales and growth will help your lender assess your ability to repay your merchant cash advance. More stable sales and consistent growth may result in a lower factor rate.
• Average monthly credit card sales: Merchant cash advances are repaid as a percentage of your daily or weekly credit and debit card sales. Your monthly average shows how likely you are to be able to repay your advance, so if you have high monthly sales, your rate should be lower.
• 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.

To calculate the cost of your funding using a factor rate, simply 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

If you’re 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 compare your options with confidence:

Advance amount x factor rate = total payback amount

$10,000 x 1.3 = $13,000

Total payback amount – advance amount = cost of advance

$13,000 – $10,000 = $3,000

Cost of advance / advance amount = percentage cost

$3,000 / $10,000 = 0.3

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

Even though an annualized interest rate like 121% may seem higher than the interest rates offered by banks, it’s important to note that your total loan costs may actually not be that much higher if you opt for funding that uses a factor rate.

Interest rates compound as you pay off your loan, which means they can add up to a significant amount over the term of your loan, especially if you have a fixed term, a large loan, miss payments, or prime lending rates change. Some loan terms also stipulate that you can’t repay your funding earlier than your fixed term length, so you’re either locked into their payment schedule or you may be subject to additional fees if you opt to pay early.

Factor rates are typically used for lending products that have no fixed term, which means you can pay them back in your own time and your cost of funding will not change. There are also no fees for paying back this type of funding earlier than expected.

Ultimately, whether a factor rate or interest rate works better depends on your business and why you’re seeking funding.

Financing with a factor rate is typically ideal for:

• 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

Financing with an interest rate is typically ideal 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 Canada Small Business Financing Program and other commercial lenders

Factor rate funding like merchant cash advances and other forms of alternative funding offer a number of advantages over financing from traditional lending institutions, including:

• Simplified applications with less paperwork and less rigorous approval requirements.
• Faster processing and approvals, with funding available in as little as one business day in some cases.
• More flexibility and more room to negotiate terms.

Many types of alternative funding are available to businesses who need funding quickly, don’t meet the strict criteria of government funding programs and other traditional lenders, or would prefer not to seek funding from friends or family members. With funding from as little as $3,000 up to $500,000, business owners can access alternative funding that suits their unique needs, including merchant cash advances, term loans, invoice factoring, and business lines of credit.