A factor rate (Money Factor) is a fixed cost charged for alternative business lending or business financing. This rate type is common with Short-Term Small Business Loans, Merchant Cash Advances, and other short-term financing or funding options. Money factors are not commonly used with lines of credit.
Factor rates are NOT interest rates or an annual percentage rate (APR.) Unlike accrued rates, factor rates are expressed as a fixed fee multiplier whereby all of the cost is charged to the principal when the business loan or advance is originated.
How Does a Factor Rate Work and How Is the Financing Calculated?
So what is a factor rate? Business leaders and funders charge a fixed cost expressed as a decimal ranging from 1.1 to 1.5 and are multiplied by the amount borrowed. In other terms, a factor rate is a percentage that shows how much “extra” you owe on a particular funding.
For example:
Principal Loan Amount: $10,000
Factor Rate: 1.25
Payback Amount: $12,500
Repayment Periods: Vary
In this example, you multiply the amount borrowed by the factor and get the total payback you owe ($10,000 x 1.25 + $12,500). The total cost for the loan was $2,500 ($12,500 payback – $10,000 loan amount+ $2,500), which is the difference between the amount funded and the amount you are responsible for paying back.
Interest Rate vs. Factor Rate Financing
Interest rates are defined as the portion of the loan of the amount loaned, which a lender charges to the borrower, normally expressed as an APR. The rate is compounded daily, meaning you are only charged based on the current principal.
Loan factors, as described above, are fixed costs and not compounded daily, which means that you are responsible for the full cost.
The clear difference between an APR loan and a factor loan is that you are responsible for the full payback on the factor rate loan whether you payoff early or not while an APR loan you are only paying interest charges on your current balance at the time of early payoff.
Also, keep in mind that the frequency of your payments also impacts APR calculations because of the timing of the collection of the money against the principal.
How Lenders Determine Your Factor Rate
In determining and calculating factor rates, business lenders and/or funders look at the following characteristics:
- Application
- Personal Credit history (credit score) of the business owner
- Business Credit
- Industry
- Time in business
- Bank Statements (Cash Flow Health)
- Average monthly deposits
- Financial Statements(if applicable)
How Do You Convert Factor Rate to APR?
First, we calculate the interest payable by multiplying the loan amount by the factor rate and calculating the difference.
Then divide the interest by the loan amount to get a decimal and then multiply this decimal by 365. Then divide this by the term (in days) to determine the annualized interest rate.
To calculate the APR, use the frequency of repayments as how frequently interest on the loan compounds (daily, weekly, fortnightly, or monthly). Then calculate the number of payments, repayment amount, and interest per frequency to build an amortization schedule to calculate the effective APR.
Calculate the fees and charges payable over a year. This is then divided by the loan amount. And then multiplied by. And then divided by the term in days. This figure is added to the effective APR to give us our final effective APR.
Did I confuse you enough? Well don't worry, a Smartbox disclosure is usually available to calculate this conversion for you and should be provided by the business funder or lender when acquiring business financing and trying to determine finance charges.
Samples of “Smart Box Disclosures”
The Bottom Line About Factor Rates
Remember to ask for clear disclosures (like the SmartBox or truth in lending) so you understand the total cost of the financing and know that early payment is not going to afford you a discount on total costs on the interest rate factor, unlike a principal and interest loan unless the lender or funder offers some type of early pay discount for paying the factor rate loan off early.
Factor rates are not bad in that they allow business lenders and funders to offer money to business owners that would not typically get approved for business financing due to the risk factors like merchant cash advances. Factor rates have opened the doors to many innovative business funding products that did not exist in years past, so this cost calculation plays an important role in today’s business lending environment.
