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.

Brian O'ConnellUpdated August 16, 2022

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If you’re in business for yourself and you’ve applied for small business funding like a merchant cash advance or short-term loan, the chances are good you’ve encountered a factor rate.A factor rate is a percentage of a loan, expressed as a decimal figure, typically between 1.1 and 1.9. The factor rate helps the borrower figure out how much will be owed on the loan, including both the loan principal amount and the total interest.The loan’s principal multiplied by the factor rate equals the total amount that the loan will cost.For example, let’s say a business owner takes out a cash advance for $10,000 and the loan factor rate is 1.2. $10,000 X 1.2 = $12,000So $12,000 is the total amount of money owed on the loan. That’s $2,000 more than the actual $10,000 principal.Banks and (more often) other lenders use factor rates as a key measure in determining the loan’s interest rate. It helps lenders estimate how much they’ll make by lending money to a small business owner.For the borrower, a factor rate can be helpful. It helps you determine exactly how much money, as expressed by interest payments, you would owe on a business loan and can be useful if you want to compare these loans against one another.How are factor rates constructed and what should you know about them? Here’s a closer look.

Factor Rates Defined

Factor rates, also known as money factors, are used by banks and lenders to clarify the exact amount of interest charged on a business loan. They’re most commonly used with short-term business loans. Factor rates are often used on short-term funding taken out by commercial merchants, like stores or restaurant owners, who need a quick cash infusion. That usually comes in a merchant cash advance, or a cash advance, from a bank or lender. It’s worth noting that this kind of funding is typically expensive when compared with interest rate funding. In a business cash advance scenario, a lender approves the short-term loan, the merchant accepts that loan, and the money is disbursed quickly. The lender will recoup its cash advance loan (plus interest) via automatic payments taken from the merchant’s future sales (often its credit card payments received). Once enough deductions from future sales are made, the cash advance is paid off.

How Is a Factor Rate Determined?

As with a lender who issues interest rate loans, a lender who offers loans with a factor rate generally also wants to know that borrowers will be able to pay the loan 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 will want a sense of your business’s financial situation.
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 Versus Interest Rates

Although it’s similar in some ways, a factor rate is not the same thing as an interest rate.Factor rates focus only on the original interest rate that’s set when the loan agreement is signed. If the factor rate on the $10,000 loan we looked at is 1.2, then that factor rate is set in stone. It won’t change over the course of the loan. And the total amount that the loan will cost—$12,000—won’t change either.Interest rates don’t work that way. Once an interest-rate loan is signed, the interest rate may change, depending on the amount of principal and interest paid on the loan on an ongoing basis. That’s due to compound interest.Let’s say that after applying for a small business loan, a business owner takes out a $10,000 loan at 5% interest. At the end of the first month, the borrower might pay $500 back, plus the interest owed on a compounded basis. But the next month, assuming there are no prepayment penalties, the business owner may decide to pay back $1,000, plus the monthly interest owed.Each month, that interest is recalculated based on the remaining loan amount, with a new balance every month. That means that the interest rate, now based on the new balance, can result in a new monthly payment owed. If you make larger payments on your loan than are required, you may be able to pay it off early and to pay less interest and less in total than you would have if you’d followed the original payment schedule.Since the factor rate on an unsecured business loan is calculated at the beginning of the loan, dependent on the original loan amount, that total loan repayment is fixed. The payments are typically deducted automatically from your business’s sales. For example that same $10,000 loan at a 1.2 factor rate, you might agree that a certain percentage of your sales could be taken out each week until you were paid off.You often can’t prepay a loan with a factor rate And even if you did, that wouldn’t change the total amount of what the loan costs.It’s also worth remembering that fees may apply to some of these loans, which can also raise their cost to you.

Pros and Cons of Factor Rate Versus Interest Rate Loans

Who would want a factor rate loan rather than an interest rate loan?Basically, the decision between a factor rate loan and an interest rate loan comes down to when the borrower wants to know the total loan amount – at the start of the loan (factor rate loan) or at the close of the loan (interest rate loan). But beyond that, there are more nuances involved. By and large, business owners who need short-term loans may favor a factor rate. That’s because loans with factor rates are typically faster and easier to obtain, though they’re also generally for smaller amounts. You might also favor a factor rate loan if you want to know what the loan will end up costing in its totality. Factor rate loans can work well for younger businesses with a steady flow of cashA business owner who wants a larger amount of money, some flexibility in paying it back, and/or a longer timetable to pay the loan off might favor an interest rate-based loan. That’s because the total loan amount is adjustable, based on repayment patterns. If your business has stellar credit, an interest rate-based loan may offer you lower interest charges. Here are some additional pros and cons of factor rate loans.

Pros of Factor Rate Loans

With a factor rate loan, the borrower knows upfront how much the loan will cost.
Some factor rate loans, usually in the form of cash advances, can be accessed more quickly than other kinds of loan.
Factor rate loans may have less rigorous credit score requirements than other loans, in part because they often have lower loan amounts.
Factor rate loans have steady repayments that are established and set from the outset of the loan.

Cons of Factor Rate Loans

A borrower will need to get special permission from the lender to pay the loan off early or otherwise change the total loan amount.
Factor rates are usually used in merchant cash advances, which don’t have high loan amounts compared to interest rate loans.
Lenders usually expect borrowers to pay off factor-rate loans more quickly, compared to interest rate loans.

The Takeaway

There are definite upsides to factor rates. They’re usually easier to calculate than interest rates, and the loans that use factor rates are typically easier to obtain than interest rate loans. What’s more, the borrower knows going into a situation what the total repayment amount will be, based on the factor rates. There are, however, some potential drawbacks to factor loans, like lower loan amounts compared to other business loans and no ability to pay down the loan more quickly without the lender’s permission.Talking candidly with your potential lender and a trusted financial specialist may pave the way for a successful factor rate loan experience. It may also help to compare possible loans side-to-side. At Lantern Credit, you can fill out one simple form and see offers from many different lenders in our network.

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About the Author

Brian O'Connell

Brian O’Connell is a freelance writer based in Bucks County, Penn. A former Wall Street trader, he is the author of the books CNBC's Creating Wealth and The Career Survival Guide. His work has appeared in multiple media platforms, including TheStreet.com, Bloomberg, CBS News, Yahoo Finance, and U.S. News & World Report.

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