If you’re confused, you’re not the first small business owner who’s wondered what factor rates have to do with getting the funding you need. Thankfully, it’s an easier concept than it may seem. Here’s more information about how they work and how you can evaluate the cost of borrowing like a pro.
Factor rates express the total cost of borrowing a specific amount as part of a business loan and are calculated once at the beginning of the lending period.
This concept shouldn’t be confused with interest rates, which are calculated more than once and represent capital depreciation. As you consider your small business lending options, be sure to consider whether your loan offer is actually a good deal for your company.
How are Factor Rates Calculated?
Thankfully, if you already understand interest rates, factor rates are fairly straightforward. This is just another way of counting the interest, fees and any applicable charges so you can look at the true cost of a small business loan. It’s not used in consumer lending at all, so many small business owners, self-employed people and solopreneurs aren’t familiar with the factor rate definition.
For an example $10,000 loan, the total cost of borrowing may be $12,500. By the time you finish repaying your loan, you’ve spent $2,500 to borrow $10,000. The factor rate in this instance is 1.25, because it’s 12,500 divided by 10,000.
If you decided to borrow $15,000 instead at the same rate, you would multiply 15,000 by 1.25 to find your new total borrowing cost, which is $18,750.
There’s no guesswork. It’s just a single upfront cost. And it’s always represented as a decimal:
Total Loan x Factor Rate = Repayment Amount
How a Loan’s Factor Impacts my Small Business Loan Costs?
Calculating your cost of borrowing tells you upfront how good of a deal you’re getting on your loan, allows you to make easier comparisons and helps with planning. Essentially, it’s important to keep in mind that loan factor rates can make borrowing seem cheaper than it actually is, although they also allow you to easily see the full cost of a loan at-a-glance.
As you consider your business borrowing options, you may find multiple offers and be in a position to compare different rates. The lower your interest factor rate, the more affordable the loan. It may help to shop around if you’re trying to find the lowest loan rate you possibly can.
Why Aren’t Interest Rates Used Instead?
Loans using factor rates do not have interest. Of course, there’s still a borrowing cost. Just because a loan doesn’t include interest doesn’t mean borrowing is free.
In a sense, you could imagine these borrowing costs as interest you have to pay on your loan, although there are crucial differences you shouldn’t ignore. On most loans, when the lender charges interest you can repay early and save money. This is because the interest rate is applied regularly at different intervals throughout the life of the loan. Even if your interest rate is 8 percent and compounded monthly, for instance, you could repay the loan a week later and avoid that cost.
It’s not so with factor rates. That borrowing cost is what you owe on your business loan even if you’re able to repay early. Even if you calculate the cost of a 1.05 factor rate and attempt to compare it with a 5 percent interest rate, you’re actually looking at two different loan costs. You can’t directly compare them.
Because these are typically short-term loans such as merchant cash advances, there may not be a long enough term for an interest rate as such. Or there may not be a term at all. Business lending options are flexible because companies have a variety of different needs that come in all shapes and sizes. Having sufficient capital for business operations is absolutely crucial—so business loans are designed accordingly.
How do I Find a Competitive Factor Rate on a Business Loan?
Shopping around and comparing loan offers can help you find the right option for your business.
Since your rate may vary based on a variety of different factors, it makes sense to consider alternatives and learn more about what impacts your rate.
What Impacts Factor Rates?
Your rate can vary from one lender to another and depends on your business health and credit history. As such, no two businesses or applicants receive the exact same rates and offers.
Business finance is complex and the lender has to be sure their own risk in lending is as low as possible, so they’ll make a strong effort to evaluate your business model and look for a solid history of strong cash flow and payment of any obligations and debts.
When you present your application, you will probably be asked for additional documentation to help the lender see how well your business is doing. And depending on the lender’s expectations, you could be offered a higher or lower rate.
Many things can influence your rate, such as:
- Bank Statements: Your business bank statements are one way you can demonstrate cash flow to your lender so they can evaluate creditworthiness and see how strong your business is. Usually, they’ll ask for at least 3 months of data, but they may need more.
- Credit Card Processing Statements: Another way to show your business is selling and you’re taking in income.
- How Long You’ve Been in Business: Generally, the older your business is, the more established and credit-worthy it is to lenders. Brand-new businesses may not be eligible for a cash advance or short-term loan right away.
- Business Tax Returns: Consistent, stable income reports on your business taxes are another form of cash flow proof that a bank or alternative lender may ask for when you apply.
Obviously, it’s usually better to have as much documentation as possible and have more than one form of evidence in case your lender needs it. As you shop around for quotes, it doesn’t hurt to ask if you’re unsure what types of proof you’ll need for your application.
Keep in mind, too, that other factors may also apply depending on the lender. Every bank and alternative lender reserves the right to use their own process and their own judgement in evaluating applications. Once you do have your rate, you’ll be able to compare the full borrowing cost with other offers you receive.
Finding the Right Loan
For your business, the right loan likely depends on a variety of factors, too. Repayment options, borrowing terms and impact on personal credit may be aspects of business borrowing that you’re thinking about as you weigh your own options.
Whatever you do, be empowered to do your own research into business lending. Find the information, advice and practical help you need to make borrowing part of your business success story. Don’t be afraid to ask questions and get specific pricing, special offers and terms when you shop around for quotes. It’s your business, and also your opportunity to find business financing that works best for your goals.