If you have researched the business finance options available, you have probably come across the term ‘factor rate’. A factor rate is a common way for pricing certain types of business finance, including short-term business loans and merchant cash advances. If you are considering a loan that is quoted using a factor rate, it’s essential that you know what it is and what you are really paying.
The factor rate is not the interest rate
The first thing to understand is that the factor rate is not the interest rate or annual percentage rate (APR). The factor rate is expressed in a decimal form, usually from 1.1 to 1.5. For example, if the factor rate is 1.25 and you’re borrowing $20,000, you will need to repay $25,000 (1.25 ✕ $20,000). You might think that the factor rate of 1.25 is equivalent to a 25% interest rate. But this isn’t the case.
With a factor rate, the fee is charged once the loan is issued, so there will be no discount if you pay it early. With an interest loan, the interest is calculated on the principal. So as you make payments and the principal decreases, the amount of interest declines as well. For example, if you get a one-year loan with a $20,000 principal and 25% interest rate (with a monthly payment and monthly compounding), you will pay back $22,810.61. So the ‘fee’ for borrowing the money is $2,810.61. This is compared to the $5,000 you would pay if you borrowed with a factor rate of 1.25.
Shortcomings of factor rates
With this method, the fee is fixed from the beginning, so you will pay the same amount even if you pay off the loan before the term ends. On the other hand, typical business loans are based on interest over time, so the sooner you pay off a loan, the less you will pay. With the example above, the borrower using a factor rate will pay back the $25,000 ($20,000 principal plus a $5,000 factor fee) even if they pay off the loan early. This can be seen as a prepayment penalty. This means there would be no reason to refinance with a lower rate loan or pay off the loan early.
Another potential shortcoming with these loans is known as ‘double dipping’. This can occur when renewing or refinancing the loan. If the lender does not remove the fee from the previous loan, the borrower ends up paying fees on top of fees on the previous loan. When a lender offers ongoing credit, allowing borrowers to renew their loan or borrow more, double dipping can become a significant issue.
Beware of simple interest rates
Another aspect to consider as what’s called the “simple interest rate”. Some business lenders quote using this rate. It can be deceptive because it’s actually much higher when compared to APR (annual percentage rate). For example, a loan quoted at an 18.95% simple interest rate is actually 33.55% when quoted in APR.
Learn more on how to compare interest rates in APR vs Simple Interest Rate: Why It’s Not So Simple.
Alternative short-term loans
When considering small business loans, an unsecured online business loan could be the answer. With Moula, for example, the application takes around 10 minutes to complete. In addition, your finances are safely and securely analysed online to determine if you meet the requirements for a loan and how much you are eligible to borrow. If approved, the funds are transferred to your bank account immediately. With loan terms between six and 36 months, Moula loans can be classified as short-term business loans.
Moula loans are 100% transparent, so there are never any hidden fees or charges. To find out more about interest rates for various business lending options, see What’s the Business Loan Interest Rate? Also, check out our business loan calculator for an estimate of loan principal and interest repayments.
