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If you run a small business, you may be feeling the effects of the COVID-19 pandemic. It’s a challenging time to manage cash flow, payroll, and other business expenses, while making sure you and your staff are safe and healthy. If you need assistance, check out the Small Business Administration's (SBA) coronavirus relief options, which include the Paycheck Protection Program, EIDL Loan Advance, SBA Express Bridge Loans, and SBA Debt Relief.If you own a small business, maintaining cash flow and covering essential expenses can be challenging at times. If you have limited options and need quick funding, you may consider a merchant cash advance (MCA). MCAs are not technically loans since they offer cash up front in return for a portion of a business’s future sales. Since they aren’t loans, MCAs do not require collateral and merchant cash advance companies typically won’t look at your credit scores to determine approval. However, there is little government regulation on MCAs, which can result in practices by some merchant lenders that are very costly to your business. If you’re considering a merchant cash advance, continue reading to learn about what an MCA is, some pros and cons, when they’re used, and how to apply for one. We’ll also explore some alternatives if you decide an MCA isn’t right for your business.
How a Merchant Cash Advance WorksA merchant cash advance is not actually a loan, but a financing option that allows small businesses (“merchants”) to get a cash advance for business expenses in return for a portion of their future sales or receivables. Merchant cash advance companies purchase these future sales at a discount in return for offering quick financing. Repayment is typically made in one of two ways:
- Taking a percentage of the merchant’s daily debit or credit card deposits
- Withdrawing funds directly from the merchant’s bank account on a fixed schedule
Factor Rate Used for Merchant Cash AdvancesInstead of a traditional interest rate, an MCA includes a factor rate, which is a decimal figure that reflects the total amount to be repaid on the merchant cash advance. Factor rates often range from a rate of 1.1 to 1.5, depending on the terms of the advance. Similar to how traditional lenders calculate interest, merchant cash advance companies calculate factor rates by assessing the potential risk of providing funds to your business. Items that may affect the factor rate you receive include:
To calculate how much you could owe on an MCA, you’d typically multiply the entire amount of the merchant cash advance by the factor rate. For example, if you’re getting a cash advance of $5,000 and your factor rate is 1.3, then the total amount you’ll owe is $6,500. You’re essentially paying 30% in interest. $5,000 × 1.3 = $6,500The factor rate does not include any additional fees that may be associated with the cash advance, so check with your merchant cash advance company to make sure you’re aware of any additional costs. This step is important, as some merchant cash advances have been known to have APRs in the triple digits.
- The type of industry your business operates in
- Your business’ financial history
- Credit/debit card sales
- Number of years in business
Small Business Loan vs. Merchant Cash AdvanceMerchant cash advance is the most common term used for such financing, but you may also see them referred to as credit card processing loans, business cash advance loans, merchant loans, or merchant advance loans. Just remember, these aren’t loans, which means they come with little federal oversight and require you, the borrower, to do your due diligence when researching your options.Traditional small business loans are different from MCAs because they provide merchants a sum of money, typically for a specific purpose, which is then repaid in regular installments. Compared to MCAs, small business loans tend to have longer repayment terms and stricter approval requirements. Where a traditional lender, like a bank or online loan provider, may look at your credit scores and require collateral, merchant cash advance companies usually do not.Small business loans come with fixed or variable interest rates, which are applied to the principal balance. Interest rates on small business loans can vary depending on the loan type and borrower, but may be lower than the factor rates you’d encounter on a merchant cash advance.While there may be fees associated with a small business loan, APRs are typically lower than those of MCAs. This means that small business loans tend to be more affordable than merchant cash advances. Examples of lending options that could be workable alternatives to MCAs include:
- Equipment financing
- Invoice factoring
- SBA loans
- Small business loans
- Online business loans
Common Uses for a Merchant Cash AdvanceOne of the most common reasons a small business owner would choose a merchant cash advance is to access quick funding for short-term business expenses. A few of the common uses for MCAs include:
Businesses of any size can use merchant cash advances, but they are common for businesses that are:
- Fill cash flow gaps: If a small business has fluctuating cash flow, which may prevent them from making bill payments or payroll, a merchant cash advance can act as supplementary funding until cash flow returns.
- Emergency/unexpected expenses: If short-term business loans are not accessible to cover unexpected expenses, small business owners can opt for a merchant cash advance that could get them cash within a couple days.
- Inventory: For small businesses with consistent credit/debit card sales, an MCA can be used to purchase inventory and then repaid with a percentage of the revenue from inventory sales.
- Seasonal fluctuations: Some businesses have significant revenue changes depending on the season. To ensure there’s cash on hand, small business owners can get a merchant cash advance to cover any expected losses during down time.
- Start-ups with little to no business history
- Those who have low or no credit, and don’t want to apply for a bad credit business loan
- Small business owners who don’t have collateral to offer
- Pioneers in new industries
- Unable to qualify for loans from banks, credit unions, or online lenders
Benefits and Risks of Merchant Cash AdvancesLike any source of business financing, a merchant cash advance comes with its pros and cons. Generally, MCAs are chosen as a last resort due to their high cost, but there may be times when it’s the right choice for your business. Let’s take a look at some of the pros and cons so you can make the right decision for your business.
Pros of Using MCAs
- Quick funding: Unlike a traditional loan, you can expect to receive funds in a matter of days.
- Minimal paperwork: Merchant lenders offering a cash advance typically require a simple application and want to see basic financial information about your business, like a record of recent credit card transactions.
- Unsecured: Business owners do not need to offer collateral to obtain a merchant cash advance.
- Payments may change with sales: If the merchant cash advance is based on a percentage of sales, the repayment amount might adjust depending on the success of your business.
- Don’t need perfect credit: If you have low credit scores, haven’t established business credit, or are struggling to get a short or long-term business loan, a merchant cash advance can help supplement.
Cons of Using MCAs
- Expensive: Factor rates typically tack on an additional 20% to 50% of the cash advance, or a rate of 1.2 to 1.5, depending on terms and conditions of the MCA. When you consider additional fees and APRs possibly in the triple digits, a merchant cash advance can be significantly more costly than a traditional loan.
- No advantage to early repayment: With a merchant cash advance, you typically pay a set amount regardless of how much of the balance you’ve paid off. Merchant cash advances do not amortize like a loan, in which case you could pay less interest when you pay off the balance early.
- Lack of government oversight: Because MCAs are considered to be a commercial transaction, merchant cash advance companies can offer cash advances to those who otherwise may not qualify for a small business loan. However, the lack of specific government regulation can also lead questionable financing practices and less protection for your business.
- Don’t promote good credit: Merchant cash advance companies are not required to report to credit agencies. If you’re trying to build good business credit, using an MCA is unlikely to help the same way a loan would.
- Hard to get out of debt: If you struggle to get loans, relying on high-APR merchant cash advances has the potential to keep you in a debt cycle that can be hard to get out of.
- Cash flow restriction: While using an MCA can help secure funding in the short term, it could hurt cash flow in the long term. If you agreed to give your merchant lender a high percentage of your daily credit/debit card transactions, for example, cash flow may run leaner during the MCA repayment period, especially if your sales are high.
Applying for a Merchant Cash AdvanceMerchant cash advance companies make it fairly simple to apply for financing, which typically involves filling out an application and providing documentation:
After you’ve been through the application and approval process, you’ll have funds deposited into your small business account. Payments are typically deducted automatically from this account until the entire merchant cash advance is paid off.
- Fill out an application: A merchant lender may ask for basic identification like your Social Security number, business tax ID (EIN), and contact information.
- Collect and provide necessary documentation: This can vary depending on the MCA company, but you may need records of credit card transactions, business banking statements, lease agreements, gross revenue, and tax returns.
- Approval: Getting a decision can take as little as 24 hours or a few days depending on the company.
- Set up credit card processing: Your business may be required to set up credit card processing with a specific partner of the MCA provider.
Alternatives to Merchant Cash AdvancesBecause of their lack of regulation and incredibly high APRs, merchant cash advances are usually considered as a last resort. Here’s a list of other small business lending options that may be accessible:
- Invoice factoring or financing: Invoice factoring and financing use unpaid invoices as collateral in exchange for a cash advance from a lender. This is different from an MCA, which is based on projected sales. Invoice factoring also typically has a lower APR than MCAs, generally falling between 15% to 35%
- Inventory financing: Funding is provided to pay for products that will be sold at some time in the future. The inventory acts as collateral for the loan.
- Equipment financing: Secured loans used for the purchase of machinery, vehicles, or other business-related equipment.
- Personal loans: Personal loans are typically unsecured and based on your personal credit history (not business credit) and can be versatile financing options. Note that some personal lenders prohibit the use of funds for business purposes.
- Commercial real estate loans: Funds for the purchase of business-related real estate like an office space or retail shop.
- Business credit cards: Similar to a business line of credit, these can be used for short-term business needs. Business credit cards use a revolving line of credit with interest only charged on unpaid balances from previous billing cycles.
- Small business loans from online lenders: Some online lenders offer similar loan options as a traditional bank, but typically have a faster approval process and may offer more options (albeit usually at higher interest rates) for people with lower credit scores.
There are a lot of options to choose from when you’re looking for small business financing. Whether you want to search for SBA programs or discover online loan options, Lantern Credit allows you to compare lenders with a simple application. We’re here to help save you time and stress so you can focus on what matters most: your business.
- Business line of credit: A short-term financing option that can be revolving or non-revolving in which you pay interest on unpaid balances.
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