What is a Factor Rate and How Is It Calculated?

What Is a Factor Rate? How Do You Calculate It?; What is a factor rate? Factor rate is a method of figuring out the interest rate on business financing options. Learn more about how to calculate factor rates.

Sulaiman Abdur-RahmanUpdated December 18, 2023

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Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.

If you’re in business for yourself and you’ve applied for sales-based financing or revenue-based financing, the chances are good you’ve encountered a factor rate.A factor rate is a percentage of a commercial financing offer, and the rate is typically expressed as a decimal figure between 1.1 and 1.7. Merchant cash advance providers typically use a factor rate to calculate your repayment costs (not including any additional fees).For example, let’s say a business owner takes out a merchant cash advance (MCA) for $10,000 and the factor rate is 1.2.$10,000 x 1.2 = $12,000So $12,000 is the total amount of money owed on the merchant cash advance if the provider doesn’t charge additional fees. Some MCA providers may charge additional fees on top of the factor rate. Below we highlight how nonbank finance companies typically use factor rates to make money.

Factor Rates Defined

Factor rates are typically used by nonbank finance companies to calculate some or all of your total costs on nontraditional commercial funding.A factor rate is typically used in the following sales-based financing or revenue-based financing products:

Inventory financing
Invoice factoring
Merchant cash advance
Purchase order financing

Factor rates on a merchant cash advance typically range from 1.1 to 1.7, and the rate is used to calculate your repayment costs (not including any additional fees).An MCA is a common type of sales-based financing that charges a factor rate, not a short-term business loan that charges interest.Recommended: Merchant Cash Advance Regulations

Factor Rates vs APR

It’s worth noting that MCAs and other sales-based financing products are typically expensive when compared with traditional small business loans. That’s because the total costs of a merchant cash advance can include a factor rate and additional fees that would typically represent a high annual percentage rate (APR) if it were a traditional bank loan.A $50,000 MCA to be repaid in six months at a 1.15 factor rate would cost you $57,500. If that same MCA had a one-time 2.5% setup fee and monthly $50 administrative fee, your total repayment cost would amount to about $59,000. These total costs are roughly equivalent to 70% APR.The APR on a small business microloan, meanwhile, can have APRs starting at 7% or 8%. Community-based microlenders may offer microloans of up to $50K.Recommended: Microloan Programs Available for Startups

How Is a Factor Rate Determined?

As with a lender who issues interest rate loans, a lender who offers sales-based financing with a factor rate generally also wants to know that borrowers will be able to pay the financing back. Even though taking payments directly from a merchant’s sales provides some security to the lender, if a borrower is perceived as more risky, it might be offered a higher factor rate.Every lender has its own requirements, of course. But across the board, in order to determine your factor rate, a lender may ask to see:

Credit card processing statements. The lender will want to see proof that you have credit card sales large enough for it to deduct payments from them.
Bank statements. A lender may want a sense of your business’s financial situation and request some of your recent bank statements.
Time in business. Typically, lenders prefer to lend to businesses that have been operating for at least a year.
Business tax return. This will allow the lender to assess the financial health of your business.

Lenders may consider other factors when determining your factor rate, but these are among the most likely components.

Factor Rate vs Interest Rates

Although it’s similar in some ways, a factor rate is not the same thing as an interest rate. As mentioned earlier, a factor rate is a percentage of a commercial financing offer, and the rate is typically expressed as a decimal figure between 1.1 and 1.7. Sales-based financers, including merchant cash advance providers, can make money by charging a factor rate.Factor rate example. A $10,000 MCA with a 1.2 factor rate would cost at least $12,000. The factor rate doesn’t necessarily tell you the total cost of the MCA, because MCA providers can charge additional fees on top of the factor rate.An interest rate is a finance charge typically expressed as an annual percentage of a borrower’s outstanding principal. State usury laws can limit the maximum interest rate that lenders charge on traditional loan products. You can typically minimize your total interest charges by paying a loan off early.Interest rate example. A $10,000 microloan with a 7% interest rate, five-year repayment plan, and no additional fees would cost about $11,880 after 60 months. The total borrowing costs would be lower if there’s no prepayment penalty and you pay the loan off early.Here are some points to keep in mind:

The interest rate doesn’t necessarily tell you the total cost of a loan, because lenders can charge additional fees on top of the interest rate charges
A merchant cash advance is a sales-based financing solution that typically charges a factor rate, whereas traditional loans typically charge interest
APR takes the interest rate and upfront fees into account, so APR can give you a better idea of a loan’s total cost than the interest rate alone

Recommended: 15 Types of Business Loans to Consider

Pros and Cons of Factor Rates

Here are some pros and cons of factor rates:

Pros of Factor Rates

Relatively easy to calculate costs upfront
Factor rate products, such as merchant cash advances, typically have fast funding times
Factor rate products may have less rigorous credit score requirements than other forms of financing

Cons of Factor Rates

Factor rate charges cannot be minimized via prepayment
Factor rates are a nontraditional commercial financing term
Can translate into APRs of 70% or higher

The Takeaway

A factor rate is a nontraditional financing term typically used by merchant cash advance providers. Nonbank finance companies may charge a factor rate and additional fees. Factor rate charges on an MCA can be more expensive than interest rate charges on a U.S. Small Business Administration (SBA) loan.If you need small business funding, Lantern by SoFi can help. Just fill out a simple form and find the right financing for your business.Lantern can help you find fast funding for your small or medium-sized enterprise.

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About the Author

Sulaiman Abdur-Rahman

Sulaiman Abdur-Rahman writes about personal loans, auto loans, student loans, and other personal finance topics for Lantern. He’s the recipient of more than 10 journalism awards and served as a New Jersey Society of Professional Journalists board member. An alumnus of the Philadelphia-based Temple University, Abdur-Rahman is a strong advocate of the First Amendment and freedom of speech.

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