A factor rate (also known as Money Factor) is a fixed cost charged for many banks or alternative business lender business loans or business fundings. Factor rates are common with Short-Term Business Loans and Merchant Cash Advances.
Factor rates are NOT interest rates or an annual percentage rate (APR.) Factor rates are expressed as a fixed fee multiplier whereby all of the interest cost is charged to the principal when the business loan or advance is originated, unlike interest rates which are accrued.
How Does a Factor Rate Work and How Is It Calculated?
Factor rates are actually quite simple to calculate. Business lenders and funders charge a fixed factor cost express 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 loan.
Principal Loan Amount: $10,000
Factor Rate: 1.25
Payback Amount: $12,500
In this example, you multiply the amount borrowed by the factor rate 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 lent and the amount you are responsible for paying back.
Interest Rates vs. Factor Rates
Interest rates are defined as the portion of the loan of the amount loaned, which a lender charges as interest to the borrower, normally expressed as an annual percentage rate. The interest rate is compounded daily, meaning that you are only charged interest based on the current principal.
Factor rates, as described above, are fixed costs and not compounded daily interest, which means that you are responsible for the full amount of factor cost.
The clear difference between an interest rate loan and a factor rate loan is that you are responsible for the full payback on the factor rate loan whether you payoff early or not while an interest rate 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 annual percentage rate calculations because of the timing of the collection of the money against the principal.
How Lenders Determine Your Factor Rate
In determining factor rates business lenders look at the following characteristics:
- Personal Credit of the business owner
- Business Credit
- Time in business
- Bank Statements (Cash Flow Health)
- Financial Statements(if applicable)
The Bottom Line About Factor Rates
Remember that when you are told you are being charged a factor rate that it is not the same as an interest rate. Ask for clear disclosures, so you understand the total cost of the financing and know that early payment is not going to afford you a discount of total costs 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 a bad thing in that they allow business lenders and funders to offer money to business owners that would not typically get approved for a principal and interest loans due to the risk factors. Factor rates have opened the doors to many innovative business funding products that did not exist in years past, so factor rates play an important role in today’s business lending environment.