What is a factor rate? How to calculate it and what it means for your small business
straight to your inbox
When you build a small business, your ultimate goal is to build it into a more substantial, more profitable corporation. However, getting from point A to point B can come with some significant growing pains.
In most cases, one of those pains is financial. You need the money to cover the production costs for purchase orders, research and development, and other activities that will help you scale up. At some point, you may even need a business loan.
This may lead you to do online searches like “How to increase your business credit card limit.” However, small business credit cards aren’t the only type of business loan out there. Moreover, they can be difficult to access. You may need alternative financing options that depend on factors like your business growth, personal credit score, and business credit. That’s where factor rates come in.
What is a factor rate?
The term "factor rate" is typically only used to mean business finance options like merchant cash advances (MCAs), invoice factoring, and other short-term lines of credit. Other lending options usually offer an interest rate or APR; both displayed as percentages. Factor rates show you how much your loan repayment amount will be in a decimal figure. This makes it easier to comprehend the total cost of borrowing.
All you need to do is multiply your loan’s principal amount by the factor rate to determine how much you’ll pay back.
Why are factor rates important to your small business?
Factor rates are important to business owners because they make it easy to determine how much business funding will cost. Knowing the cost associated with short-term financing is crucial when managing your business’s money.
As mentioned above, you can determine the total cost of a loan by multiplying the principal amount of the loan by your factor rate. For example, if you take out a loan for $10,000 with a factor rate of 1.25, you’ll pay back $12,500 (1.25 X $10,000). The total cost of borrowing $10,000 under these terms would be $2,500. Since you know the total cost of the loan will be $2,500, you can use that information to determine if there are any lower-cost options available to you.
Factor rate vs. interest & APR
The first difference between factor rates and interest rates or APRs is that interest rates and APRs typically apply to most types of loan while factor rates usually only apply to short-term business loans.
However, that’s not the only difference you should consider when you decide which lending options are best for your business. Find what you need to know about the factor rate vs. interest rate comparison below.
Factor rate vs. interest rate
There are a few core differences between factor rates and interest rates:
- How they apply: Factor rates apply only to the original principal balance of the loan. Interest rates apply to the total balance of the loan at each billing cycle.
- What they include: Factor rates include all costs associated with the loan, while interest rates only include interest-related fees.
- Cost variability: The cost of a factor rate-based loan will not change depending on how fast you pay the loan off. The cost of an interest-based loan will increase the longer it takes to pay the loan off.
Factor rate vs. APR
The key differences between factor rates and annual percentage rates (APRs) are as follows:
- How they apply: Factor rates only apply to the original principal balance of the loan, while APRs are charged for the life of the loan.
- What they include: Both factor rates and APRs include all interest costs and additional fees associated with the loan.
- Cost variability: Factor-based loans cost the same regardless of how long it takes you to pay them off. APR-based loans have increasing costs the longer it takes to pay off the loan.
How to compare your options
The best way to compare loans is to compare how much they cost over time. To do so, you’ll need to convert your factor rate into an APR that you can compare to interest-based loans. Here’s the formula:
There are a few steps to this formula:
- Subtract 1 from your factor rate.
- Multiply the answer from step 1 by 365.
- Divide the answer from step 2 by the number of days you expect it will take to repay your loan.
- Multiply the result from step 3 by 100 to determine the APR your factor rate represents.
For example, if you have a $10,000 advance amount with a factor rate of 1.25 that you expect to pay off in 90 days, your formula looks like this:
Keep in mind that factor rates are typically higher in terms of annualized interest rates because they’re generally used when funding high-risk short-term business loans.
How to calculate your factor rate
If you’re considering a small business loan, you can quickly calculate your factor rate to determine how much your loan will cost before you sign on the dotted line. The good news is that doing so is as simple as multiplying your loan amount by your factor rate.
For example, if you borrow $5,000 with a 1.3 factor rate, you’ll have to pay $6,500 to pay the loan off. Taking this a step further, let’s say you’re expected to pay the $5,000 off within 120 days. You could use the following formula to determine what APR your 1.3 factor rate represents.
How lenders determine your factor rate
Lenders consider several factors about your business when they determine your factor rate. The most important include:
- Industry: The type of business and industry the business applying for the loan is in plays a major role in factor rates because different business types come with other risks. The higher the risk your business poses to the lender, the higher you can expect your factor rate to be.
- Time in business: Companies that have been in business for longer are more likely to pay their debts as agreed. Therefore, the longer you’ve been in business, the better your factor rate will likely be. On the other hand, if your business is very new, you may be required to pay a significant factor rate.
- Average card sales history: Factor-based loans are typically paid through monthly credit card sales. When customers slide their credit cards, a percentage of the gross amount for each sale is held to pay back their loan. The more credit card sales you have, the faster the lender will be paid, so higher sales volumes often equate to lower factor rates.
- Creditworthiness: Your personal credit score and business credit history will likely play a role in your factor rate. The better your personal and business credit scores are, the better you can expect your factor rate to be.
Keep in mind, your lender may need to see your balance sheet, cash flow statement, and bank statements before they tell you your factor rate.
Your lender will tell you your factor rate before you agree to take the loan. Your lender uses a variety of factors to determine your factor rate based on the risk lending money to your business poses.
Factor rates are fixed and only apply to the beginning principal balance of the loan. That’s not the case with traditional interest rates and APRs, which are variable costs that can change at any time.
It’s within our finance culture to want lending costs at or below averages, but average factor rates vary wildly by factors unique to your business, so it’s impossible to give you a realistic range of what a fair factor rate would be without knowing more about you and your business.
You can convert factor rates to APRs using the following formula.