How to calculate the factor rate for small business financing
If you’re the owner of a small business, you understand how daunting managing your cash flow can be. You need to make sure that you can not only keep the lights on, but also cover emergency expenses, payroll, and be able to take advantage of opportunities for growth that arise.
One such critical opportunity is accessing alternative forms of small business financing to thrive in the face of sudden uncertainty. In this post, we’ll discuss how to calculate interest factor and the difference between conventional interest rates and factor rate.
Once you understand the financial implications of factor rate, you’ll be able to take advantage of tools that can help you manage your business, such as merchant cash advance factor rate financing.
What is a factor rate?
A “factor rate,” also called a “buy rate,” is a means to express interest paid on various types of loans. This allows you to identify the full cost associated with a prospective funding source, and is a relatively easy calculation.
Factor rate payment calculations differ from more common expressions such as conventional interest rates or annual percentage rates (APR.) Factor rates are defined as the additional amount of interest over the principal of a loan.
This is as opposed to the interest over time that is calculated with a conventional interest rate or APR calculation. It is generally easier to calculate interest factor than other forms of interest.
A factor rate is usually expressed as a number starting above 1.0 and above. Most factor rates are between 1.1 and 1.5. The loan factor formula is X=Y*F, where Y is the principal of the loan, F is the factor, and X is the final principal and interest due. Once final principal and interest are calculated, monthly factor rate payments are found simply by dividing the entire final repayment amount by 12 (for a yearly repayment period).
Interest payments vs factor payments
Interest rates compound over time, whereas factor rates do not. A variety of payment terms exist for factor rate loans. The significant difference between simple interest and factor rate loans is that factor rate loans do not compound and are therefore easier to calculate.
Most interest rate factor loans are merchant cash advance loans. These products are cash advances against incoming accounts receivable, which can act as collateral.
The marquee advantage of merchant cash advance factor loans, or invoice factor loans, is that the entire application process only takes hours or days, and they are approved more quickly. Interest rate payments include compounded interest; a factor payment does not.
As a business owner, it’s prudent to look carefully at overall financing terms. What may seem like a good deal might not match your current cash flow. Always review your short-term financing plans with both your in-house finance team and with your accountant.
About merchant cash advance factor rates
A merchant cash advance is a loan from a merchant cash provider, such as a credit card servicing company, against future sales and invoices.
Using this financing tool, the merchant processor or bank sets a financing factor, usually between 1.2 and 1.5. Your lender calculates this number based on their assessment of how much risk they’ll take in lending to you. This is based on data like payment and cash flow history to which the merchant processor will have access.
Learning how to calculate interest factor is easy. To calculate the principal that will be due back on the loan, just multiply your advance amount by the factor to find out how much you owe the lender back.
So, for example, say you need a cash loan for $40,000. Your merchant processor sees that you have that amount in invoices. Your lender has assigned you a rate of 1.3. That means you will owe your merchant processor $40,000 X 1.3=$52,000.
When is financing with factor rates the right choice?
Generally, factor rates are better when you need cash right away—say to make payroll or pay outstanding debt. However, factor rates are higher when compared to more traditional financing.
It helps to think of this structure as paying a premium for faster access to cash.
Because of this, it’s a good idea to shop around and exercise caution. Consider whether the high interest you will be paying is worth the time saved in getting the funds you need now. Up next, we will address how to calculate interest factor.
How to calculate interest factor
Let’s say that you need $2500 quickly. You have a choice to either get access to a loan at a 15% interest rate over 3 months or 90 days. For our factor rate loan, we choose a factor rate of 1.5.
Interest rate factor formula:
The simple interest formula is I= r*A*m/n, where:
- r is the simple annual interest rate
- A is the loan balance
- m is the number of time periods elapsed (in this case, months)
First, let’s look at the regular interest loan and its monthly payments. Using this formula, we get these numbers:
(0.15) * $2500 * 3 periods (1 month each) / 3 months = $375, or $125 paid every month for interest due. Then, add $833.33 for principle, resulting in monthly payments of $958.33 ($125+$833.33). Total principal plus interest paid would be $2875.00 (3*$958.33).
Factor rate interest is much simpler to calculate. All you need to do is multiply the principal by the factor rate. In this case, $2500 * 1.5 = $3750, paid in full when called due by the loan terms. Factor rate loans are usually immediate, short-term with higher interest rates.
Factor rate financing: is it right for your business?
Here at L3 Funding, we’ve spent years helping businesses like yours make the right decisions regarding short- and long-term merchant funding products. Get in touch with us if you need help with merchant factor loans or other short-term financing products. We’d be happy to help!