Below, we’ll delve further into what a factor rate is, how it works, and how to calculate it.
Definition and Examples of Factor Rates
A factor rate is used to calculate the borrower’s cost of taking out a loan—including principal amount and total interest—and is expressed as a decimal. It is typically used when businesses seek out short-term funding such as merchant cash advances. For example, Joe Smith Extrusion Company takes out an advance that has an associated factor rate of 1.2. That means that if Joe’s company borrows $1,000, it will pay back $1,200. Typically, factor rates will fall between 1.1 and 1.5, designating how much you’ll be paying back on your business loan. However, the factor rate you qualify for will depend on criteria such as business tenure, your industry, revenue, and financial projections. While factor rates are somewhat comparable to interest rates, or APR (annual percentage rate), there is a key difference. While factor rates apply only to the original amount borrowed—and don’t compound or change as you pay off your loan—APR will change as your principal loan amount drops.
How Factor Rates Work
While factor rates are specifically used for business financing (not personal loans), they typically aren’t applied to traditional business loans. In fact, unless you apply for a merchant cash advance or another alternative form of small business funding like a short-term loan, you may never see the term applied.
Will Your Factor Rate Be High or Low?
Factor rates will vary depending on your answer to several key questions including:
What is your industry? If you’re a seasonal business you may have to cope with a higher factor rate. The same is true if you’re in a risky business or in an industry that’s on the decline (such as travel agencies).How long have you been in business? The longer you’ve been in business, and the stronger your track record is, the lower your factor rate will likely be.Is your business stable and growing? If your business is stable and growing, you’re a good credit risk. If not, you may pay for your lack of stability with higher factor rates.
How To Calculate Factor Rates
It’s a fairly straightforward process to calculate factor rates. Simply multiply the principal amount you’re borrowing by your factor rate. For example, if you’re borrowing $1,000 at a 1.3 rate, multiply 1,000 x 1.3 and you’ll find that you will be paying $1,300 for your loan.
Are Factor Rates Higher Than APR and Interest Rates?
Loans that use factor rates are sometimes, but not always, higher than those with interest rates or APR. That’s because, even if the rate appears higher at first glance, the latter type of loans:
Change over time for many different reasons. For example, your APR may go up if you miss a payment. And even if you don’t miss a payment, APR may go up if the prime interest rate goes up. Often stipulate that you may not repay the loan early. That means you have less flexibility with your money. May be out of reach if your business has a poor credit history May take a long time for the application process as lenders to decide whether you qualify
