Liquidity and cash flow management are critical to any business, especially for businesses in a growth stage or those looking to quickly scale their operations. However, businesses in this situation may have difficulty securing traditional business loans or lines of credit. Not only that, the process for a loan application can take time, which works against those businesses that need cash fast.

A financial product known as a merchant cash advance (MCA) helps to fill this need. In most cases, you can obtain an advance on your sales in 48 hours or less. Once you receive the money, you can use it for just about any legitimate business purpose, providing a great deal of flexibility.

While MCAs are very useful, they have costs involved, and many of the costs of merchant cash advances are calculated in ways that most businesses are unfamiliar with. This can make it difficult to determine the total cost of capital with a MCA.

To help you understand the full costs of merchant cash advances, we’ll outline exactly how they work regarding repayments, fees, and factor rates.

Understanding MCA Factor Rates

The most important aspect to understand about merchant cash advances costs is that they are not based on interest rates.

Most business loans, equipment loans, and lines of credit use interest rates. These are easy to calculate, and most small business owners completely understand how to interpret them to determine the cost of their loans.

However, MCAs use a factor rate to determine your repayment amount. This amount is sometimes referred to as interest, but it’s actually more of a fee. Understanding factor rates is key to the efficient use of merchant cash advances.

Because it’s a fee, this amount never changes and is never recalculated over the life of the loan. 

With factor rates, paying the loan amount back earlier does not impact your fees or costs. You will pay the same amount if you pay the loan back earlier.

Understanding Factor Rates

A factor rate is a number by which your total loan amount is multiplied. Most factor rates will be a number between 1.2 and 1.5. However, most factor rates fall in the middle of those two extremes.

The merchant cash advance company determines the factor rate after you go through the various approval processes.

The following criteria help determine your factor rate.

Length Of Time In Business

The minimum time in business to qualify for an MCA is six months, but most lenders require at least 12 months as a minimum. The longer you have been in business, the lower your factor rate generally is.

This is because the lender has more history to base their decision on.

Monthly Credit And Debit Card Sales

A percentage of your debit and credit card transactions pay back MCAs. The higher your monthly sales and the lower your factor rate, the lower it is generally.

Your Business And Industry

Your factor rate will generally be lower if you’re in a stable industry with good predictability. Newer businesses in niche or nascent industries will generally have higher factor rates.

Newer, unstable, or seasonal industries with large fluctuations create more risk for lenders who rely on your sales being consistent throughout the loan.

Personal Credit Score or Business Credit

MCAs are often a viable option for those with bad credit, but credit can still impact your overall factor rate. The better your credit, the more likely you will receive a lower factor rate. However, this isn’t the main deciding factor, and it may have no influence depending on your other information.

Just be aware that MCAs typically accept applicants without always requiring good credit, with an acceptance rate of about 90% among all applicants.

It’s also important to note that different MCA financial institutions may interpret your criteria differently. For example, a lender with extensive experience in your industry will be better at assessing your risk.

Even a small lowering of your factor rate can save you thousands of dollars. Being aware of these factors and interpreting them are key to keeping your MCA costs as low as possible.

Calculating Your Costs For An MCA

Now that we’ve explained how a factor rate is determined, we want to explain exactly how they are calculated to help with the cost-benefit analysis of MCAs.

To begin, let’s assume you qualify for a $70,000 MCA with a factor rate of 1.2.

To determine the total amount you pay back, multiply the factor rate by the loan amount.

In this case, $70,000 X 1.2 = $84,000

Subtract $70,000 from $84,000, and you get $14,000. Thus, your loan cost is $14,000.

Most MCA lenders will provide a merchant cash advance calculator on their site so you can see your total repayment amount when applying.

Just remember that because MCAs utilize a factor rate, they consider the $14,000 as a fee and not interest.

MCA Interest Rates Vs. Factor Rates

Factor rates are usually foreign to most business owners when considering short-term financing costs. So, it is best to convert your factor rate into an annual percentage rate (APR) like a traditional bank loan. This will help you determine the true cost of the loan in terms that you understand better.

Keep in mind that lenders consider MCAs short-term, high-interest loans, so the APR will be significantly higher than that of traditional loans.

You need to do a few calculations to determine your APR based on your factor rate.

The first step is to determine the percentage cost of the loan. 

Using our previous example, we already know the loan cost, which is $14,000. To determine the percentage cost, we divide the cost ($14,000) by the original loan amount ($70,000)

In this case, we get a percentage rate of .2%

$14,000/$70,000 = .2

Next, we calculate the annualized rate. To do this, you simply multiply your percentage rate (.2) by the number of days in a year (365).

.2 x 365 = 73

Now, we simply divide the result (73) by the total amount of repayment days estimated. Let’s assume the number of repayment days is 180.

73/180 = .4055 

Multiply .4055 by 100 to get the percentage, which is 40.55%

Your APR for this loan example is 40.55%.

As you can see, this is a relatively high APR compared to most traditional loans. We also used a factor rate on the lower end of the spectrum. Higher factor rates and different repayment lengths can drive the APR to over 100%.

However, the benefit of an MCA is the overall approval rate, the speed at which you receive your funds, and the daily payments from your credit card sales.

In the right situation, the tradeoff of a high APR makes financial sense. However, you have to be aware of the total cost and the APR to make the right decisions and receive the lowest rates.

Breakdown of MCA Repayment Terms

We’ve gone over how to calculate the factor rates, the APR, and the total amount you must pay back to cover an MCA. 

MCA repayment schedules differ from traditional loans, just as factor rates do. This means there are different strategies for managing MCA repayments, and you have to analyze the pros and cons of each one to make an informed decision.

With an MCA, you agree that the MCA provider withdraws a set percentage of your daily credit and debit card sales. For example, you agree to a deduction of 10% of your daily merchant account sales to go toward paying back the merchant cash advance.

Let’s assume you have $10,000 in credit and debit card sales daily. In this example, the system will automatically deduct $1,000 each day.

The deduction is a percentage, so if your sales are lower or higher that day, the amount adjusts. So, if you have a slow sales day, you do not default on the loan or the payment. It’s simply lower.

In our previous example, we estimated the length of the daily payments to be 180 days. Your MCA provider determines this based on the amount borrowed, factor rate, and daily/monthly credit card sales.

MCA payback ranges typically range between 3 months and 18 months. Adjusting the payback period can help with financial planning for MCAs.

You do not make payments yourself each day; instead, the MCA provider coordinates deductions with your merchant account and payment processor. Your merchant system automates deductions, and you don’t need to intervene during the process.

Fixed Bank Withdrawals

Fixed bank withdrawals are less common but work similarly to daily automatic withdrawals.

With fixed withdrawals, the amount is the same regardless of your sales for that period. So, if you have a slow period, it can create difficulties that you did not anticipate.

This also means that your payback schedule is more definite. You will know exactly how many days it will take to repay the MCA. Daily percentage withdrawals can change the total time as your sales fluctuate.

When a business doesn’t do most of its transactions with credit or debit cards, it can use fixed withdrawals. For example, a mostly cash business may need fixed bank withdrawals.

Regardless of the method, lenders still calculate the factor rates and APR similarly.

Hidden Fees In MCAs

Like many other financial products and loans, there are fees involved with MCAs that are in addition to the factor rate.

Sometimes, the MCA provider fails to disclose all these fees, so customers refer to them as hidden fees. You may miss some of the fees if you don’t review your MCA offer carefully.

Sometimes, these fees can go as high as thousands of dollars, so it’s important to be aware of them.

Some of the most common fees with MCAs are as follows:

Origination & Underwriting Fees

Many loans have origination or underwriting fees, and MCAs are no different. However, you can try to negotiate these fees to avoid excessive origination fees.

Origination fees can range anywhere from $1,000 to $3,000. The MCA provider automatically deducts these fees from your borrowed amount.

So, if you borrow $10,000 with an origination fee of $1,000, you will receive $9,000 when the amount is wired to your account.

Application Fees

These are fees when you submit your application. They may charge you for these separately or deduct them from your loan amount.

Administrative Fees

These are fees for managing the MCA and the deductions over the life of the MCA.

Bank Fees

The lender also charges the borrower any fee for wire transfers or other costs incurred in moving the money.

In most cases, the MCA provider will deduct all fees from your borrowed amount before disbursing it to you. This is why it’s so important to understand all fees before you agree to the MCA terms.

Comparing MCA Fees

Comparing MCA fees across different providers can save you thousands of dollars over the life of the MCA.

You may find it difficult to compare fees because each provider can use different names for each fee. Because of this, you want to understand the full fee structure and the total fee amount due.

Although a breakdown of fees is helpful, you need to determine the total amount first. A surprise fee you learn about after the money is transferred can completely change how you plan on using the money.

Remember, there is nothing wrong with shopping around and comparing different offers. If a provider is unwilling to explain each fee to you, it’s likely a sign that there will be hidden fees when you complete the process.

MCA Vs. Traditional Loan Costs

There’s no question that a merchant cash advance costs more than a traditional loan like a Small Business Administration SBA loan. But those higher costs come with benefits that traditional lenders simply can’t offer you.

Below are how the costs of merchant cash advance short-term business loans compare to traditional business loans and similar types of funding.

Interest Rates

SBA loans typically have interest rates between 10% and 15%. This is lower than an MCA, which typically has comparable APRs of 40% to over 100%. 

You will definitely pay less for a traditional loan when it comes to the interest paid.

Paying The Debt Early

With a traditional loan, paying the debt early helps reduce the cost of business financing. 

With an MCA, the amount you owe or the loan cost does not change if you decide to pay it back early.

So, there is no chance to save money by paying the debt early with an MCA.

Lines of Credit & Online Loans

Business lines of credit can vary quite a bit, and interest rates can range from 5% to over 40%. In some cases, this makes a business line of credit similar to some MCA terms.

With a business line of credit, you replenish the credit as you make payments. With an MCA, you will need to apply for a new MCA if you need an extended line of credit beyond the original amount.

Avoiding High MCA Costs

The best way to avoid high merchant cash advance costs is to perform thorough research before applying for and accepting an MCA offer.

As we described earlier, familiarize yourself with the fee structure, such as factoring, and how it relates to APR.

You’ll also want to familiarize yourself with all the typical fees, such as origination and underwriting fees. 

Before accepting the MCA offer, ensure that you are aware of every fee involved. Read the offer carefully, and don’t always trust a representative to inform you of every fee.

Are MCAs Worth The Cost

Yes. However, like any financial instrument, one must use them in the right situation.

When used incorrectly, an MCA can leave your business in a worse position than before you borrowed the money. You want to consider the daily repayment impact on cash flow and how that affects your operations.

MCAs are best for businesses with a proven business model and sales history but need a cash injection to scale or take advantage of an opportunity. Smart financing for businesses requires carefully studying the total cost of the loan and how you manage the repayments.

If your business has underlying structural problems or a failing business model, an MCA will likely push you further into debt. Cost-effective business funding options like an MCA work best when you can become profitable very soon after receiving the funds.

Building a house is all about using the right tools for the right job. Building a business is no different, and you want to use the right tools in the right situations.

If your business is solid and an injection of fast cash will allow you to leverage an opportunity for greater profits, then an MCA is a viable option when traditional loans are unavailable.

Frequently Asked Questions About the Costs of Merchant Cash Advances

What is a merchant cash advance?

A merchant cash advance (MCA) is an alternative short-term financing option for businesses that allows them to borrow funds based on their future credit and debit card sales. It is directly tied to the payment processor rather than a bank or other financier. 

What is the difference between interest rates and factor rates?

Traditional loans have interest rates, which are a percentage of the loan amount that the borrower owes each year. However, MCA factor rates are a singular fee the borrower would owe to accept the cash advance and are typically higher than interest rates.

How are factor rates determined?

A merchant cash advance provider or payment processor will determine a merchant’s factor rate on an advance based on their sales history. Typically, credit score does not play a role in this determination. 

Are merchant cash advances worth the cost?

MCAs can be worth it for businesses with a proven sales history that need a fast cash injection to take advantage of a growth opportunity. However, if a business is currently struggling, an MCA might leave it worse off than when it started.