What Is A Factor Rate For Small Business Loans?

If you’ve ever had a mortgage or car loan, you’re familiar with interest rates. However, if you start exploring small business funding, you’ll encounter something known as a factor rate.

A factor rate is not the same as a traditional interest rate or APR. Fortunately, we’ve compiled this guide to help you understand what factor rates are and how the affect the cost of borrowing before you sign a loan contract.

What Is A Factor Rate?

Typically, you’ll see factor rates associated with short-term loans and merchant cash advances, although they occasionally pop up elsewhere.

Overall, factor rates provide an easy and straightforward way to calculate fees. While this sounds great in theory, the simplicity of factor rates can disguise just how high the cost of borrowing actually is. Factor rates also make it more difficult to compare loans.

Factor rates are usually written as a multiplier (i.e., 1.2). To determine your total repayment, your borrowing amount will be multiplied by the factor rate. The calculation is as easy as that:

Borrowing Amount × Factor Rate = Total Repayment

Using the equation above, a borrower that receives a $10,000 loan with a factor rate of 1.2 will have to repay $12,000. In this example, the fee for borrowing, called the fixed fee, is $2,000.

Sometimes, factor rates are written as a percentage. Using the example above, your factor rate would be 20%, meaning that the fee is 20% of your borrowing amount. Even if the factor rate is written as a percentage, be aware that a factor rate is not equivalent to an interest rate. 

Factor Rates VS Interest Rates

Although factor rates and interest rates appear similar, there are some important differences which potential borrowers need to be aware of.

As shown above, fixed fees are only calculated once, before the loan is issued. The fee will stay the same, regardless of how long repayment takes.

Interest rates are accrued over time — the longer your loan is outstanding, the more fees will build up. Where it gets tricky is that you probably will have a higher factor rate the longer your term is, so in some ways you can think of the interest the loan would have accumulated as being “baked in” to the factor rate.

Factor rates and interest rates are both legitimate ways to calculate fees. However, they cannot be compared apples-to-apples. A 20% factor rate is not the same as a 20% interest rate (even if they are for a year in length).

For comparison’s sake, a one year loan of $10,000 with a factor rate of 20% would have a total financing cost of $2,000, whereas the same loan with a 20% interest rate would have a total financing cost of about $1,116.

Drawbacks Of Factor Rates

Although factor rates appear incredibly straightforward, some lenders use practices that are not immediately apparent, but can drive up the cost of your loan. The most common practices are prepayment penalties and double-dipping. 

Prepayment Penalties

Because fixed fees are determined ahead of time, you cannot save money for repaying before your term is up. If you have a total repayment of $12,000 and a term length of 24 months, you often have to pay the full amount, regardless of whether you’re repaying in six months, one year, or after the full 24 months.

For comparison’s sake, you can save money on loans with an interest rate. Because the fees are accrued over time based on how much money you have outstanding, the fees are halted if you pay off your loan, or effectively reduced if you overpay along the way.

Fortunately, many lenders that use factor rates do actually offer discounts to merchants who repay their loans early. Typically, the lender will forgive a percentage of the remaining fee if you repay early. For example, a lender might forgive 25% of the fee for early repayment. Just don’t assume they’ll do it unless they explicitly say so.

Double-Dipping

Double-dipping compounds the problems introduced by the inherent prepayment penalty associated with factor rates.

Double-dipping is typically a problem when you are refinancing or renewing your loan. If your lender does not forgive the fee from the old loan, you are essentially paying fees on top of the unpaid fees on your old loan.

Because many lenders operate like quasi-lines of credit, in which borrowers are often eligible to renew their loan or borrow more money, double-dipping can become a big problem.

If you are thinking about getting a loan with a factor rate, and are considering renewing or refinancing down the line, find a lender that does not double-dip. The only way to avoid double-dipping is to work with lenders who do not practice it.

How To Evaluate A Factor Rate Offer

Comparing one factor rate to another is actually really easy: the lower the factor rate, the cheaper the loan.

What this doesn’t account for, however, is additional fees (such as origination fees) and how punishing your repayment schedule will.

The go-to tool for comparing financial products is the annual percentage rate (APR). Expressed as a percentage — not to be confused with an interest rate or a factor rate — the APR is a rough estimate of the yearly costs of a loan.

APRs do factor in those supplemental fees we talked about earlier. If a loan has a relatively low factor rate but tons of hidden fees, that will raise the loan’s effective APR. The higher the APR, the more expensive the loan.

As we covered above, you’ll also want to consider whether the lender double-dips and offers early repayment incentives, as these won’t be reflected in your effective APR.

Factor Rate Calculators

To calculate factor rates and the cost of borrowing, you can either dive into spreadsheet formulas, or you can cheat and use one of our handy calculators! You can use the embedded ones below, or go to our MCA calculator or STL calculator pages.

While MCAs and short-term loans share a few qualities, they are different financial products, so I recommend using the appropriate calculator above.

The Bottom Line On Factor Rates

Factor rates are a relatively new way of calculating fees, but they’re here to stay. Fortunately, as long as you’re aware of the few practices that can affect your savings, fixed fees are very easy to understand.

Ready to tackle factor rates head-on? Start searching your funding options with our list of the best short-term loans for businesses.