Factor rates are used for alternative forms of financing, commonly associated with short-term loans or merchant cash advances. It differs from traditional interest rates, where instead of being expressed as a percentage, a factor rate is expressed as a decimal and represents the total cost of repayment.
Essentially, a factor rate represents the total cost of financing when borrowing funds. This means that the principal amount of funding will be multiplied by the assigned factor rate, which is represented as a decimal value, and equates to the total fixed amount you’ll pay—inclusive of the original loan amount and the fee charged.
In this article, we will walk you through how factor rates work and how to calculate it.
Key Takeaways:
- Factor rates can be used to quickly calculate the total cost of financing, inclusive of the original funding amount and expected fees.
- Financing associated with factor rates can be expensive and typically has a short repayment period.
- To compare rates, you can convert the factor rate into Annual Percentage Rate (APR) to better determine total financing costs.
How Factor Rates Work
Generally, factor rates range from 1.1 to 1.5, and this essentially means that you’ll be expected to repay 110% to 150% of the original loan. The applicable rate will vary per lender depending on factors such as business industry, time in business, and sales revenue.
It’s important to note that factor rates are a fixed cost, which doesn’t change over the course of repayment and doesn’t fluctuate like traditional fixed or variable interest rates. This lets the borrower know exactly how much they will be expected to repay, including the original amount and the charged fee.
That said, factor rates are usually tied to expensive forms of financing that are designed to be repaid within a short period. They are typically suited for businesses that need quick access to capital and are ineligible for traditional financing methods.
Factor Rate vs Interest Rate
Factor rates differ from the traditional interest rate structure tied to most small business loans and are generally associated with higher-risk loans such as merchant cash advances (MCAs), some business lines of credit, or other short-term loans that are expected to be repaid quickly.
Traditional interest rates are calculated by multiplying the current balance of a loan by the applicable percentage rate, decreasing the overall payment over time in accordance with the repayment schedule. In contrast, factor rates are calculated by multiplying the assigned decimal rate by the entire upfront financing amount and only apply to the original amount borrowed.
The table below has some comparisons that outline the major differences between interest rates and factor rates.
Factor Rate | Interest Rate |
|---|---|
Is shown as decimal value (1.1, 1.5) | Is shown as percentage value (7%, 10%, etc.) |
Applies only to the original loan amount | Applies to the remaining balance of the loan |
Is used mainly for alternative short-term financing like MCAs and lines of credit | Is used for a wide variety of common business loan types |
Has a fixed rate throughout the course of the term | Has fixed or variable rates |
Can be more expensive overall due to fixed payment, with usually no prepayment discount | May give you the option to pay off the loan early and save money |
How to Calculate a Factor Rate
You can calculate the total cost of financing by multiplying the assigned factor rate by the total amount of funding you receive. The formula is:
Total Cost of Financing = Factor Rate × Funding Amount
For example, if you were to get funding in the amount of $250,000 and the provider assigned a factor rate of 1.2, we can determine the total cost of financing by multiplying $250,000 × 1.2. This equals $300,000 and represents the total amount you will repay to the lender.
Calculating the Total Fee
If you’re looking to calculate the total fee charged, you can subtract the original funding amount from the previously determined total cost of financing. In this example, we would use the formula:
Fee Charged = Total Cost of Financing – Original Funding Amount
Using our previous values, this would be $300,000 – $250,000 = $50,000. This means that you’ll pay a $50,000 fee in excess of the original loan amount, which can be expensive considering most loans associated with factor rates have a short repayment term.
How to Convert a Factor Rate
You can convert the factor rate into APR to help you compare the best rates among lenders and get an overview of just how much your financing request will cost.
Using the same example values as above, we can calculate the conversion into APR by following the steps below:
Step 1: Figure the total cost of financing
- Formula: Factor Rate × Funding Amount = Total Cost of Financing
- Example: 1.2 × $250,000 = $300,000
Step 2: Compute the total fee
- Formula: Total Cost of Financing – Original Funding Amount = Fee Charged
- Example: $300,000 – $250,000 = $50,000
Step 3: Determine the percentage cost
- Formula: Fee Charged ÷ Original Funding Amount = Percentage Cost
- Example: $50,000 ÷ $250,000 = 0.2
Step 4: Calculate the APR
- Formula:
- Percentage Cost × 365 = X
- X ÷ Loan Repayment Period (in Days) = APR
- Example:
- 0.2 × 365 = 73
- 73 ÷ 182 (based on a 6-month repayment period) = 0.401, or 40.1%
Keep in mind that these calculations may not offer the full scope of how much financing will cost across various lenders, but it is a good starting point that can help you budget accordingly and determine if this rate structure is the right form of financing for you.
How Lenders Determine Your Factor Rate
There are various considerations a lender may take into account when determining your factor rate. Generally, when evaluating your creditworthiness as a borrower, they want to ensure that you’re able to meet debt obligations since most financing associated with factor rates can be costly and require the borrower to repay funds quickly.
That said, the better your qualifications, the better your chances of getting favorable rates. Here are some criteria that may be taken into consideration:
- Credit history: In getting any type of financing, lenders will want to know that you have both a strong personal and business credit history and have a good track record of managing your finances.
- Business financials: Lenders will typically request documentation inclusive of bank statements, tax returns, income statements, etc. With this information, they can determine whether you have the means to repay the loan.
- Time in business: Many providers will require that a business be operating for a certain amount of time before issuing financing. This helps to make sure the business is established and to mitigate risk.
- Business industry: Some lenders may have limitations regarding the industry your business operates in. This is ultimately because some industries are riskier than others and may impact your ability to get financing.
- Cash flow: Lenders will want to ensure that you have the revenue to pay back any funds you borrow. By maintaining a positive cash flow, you may be able to secure a lower rate. This is especially true when getting an MCA since it is typically repaid based on a percentage of your credit and debit sales.
Frequently Asked Questions (FAQs)
Calculating a factor rate involves multiplying the assigned factor rate by the total funding amount, which will provide the total cost of financing or the overall expected repayment amount.
The main difference between the use of an interest rate versus a factor rate is the type of financing that the rate is applicable to. Interest rates can be either fixed or variable, are shown as a percentage, and are calculated based on the current balance of a loan. Factor rates are fixed, shown as a decimal, and are calculated using the total initial funding amount.
A good factor rate typically ranges from 1.1 to 1.5. Essentially, this means that you’ll pay back 110% to 150% of the initial funding amount you agreed to.
Bottom Line
Factor rates and the type of financing associated with them are often expensive and considered to be a higher risk when compared with traditional interest rates. They are utilized differently than standard interest rates and are based on the total cost of financing, rather than the remaining balance. Before proceeding with financing that deals with factor rates, be sure it fits your business needs and budget.
