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The Alarming Truth About MCA Debt: How to Understand Factor Rates

Vintage scale representing the phrase from apples to oranges for a post about merchant cash advance debt

When it comes to financing your business, you may have heard of merchant cash advances (MCAs) as a quick and convenient option for obtaining capital. While MCAs are easy to qualify for and offer immediate access to funds, it’s essential to understand the true cost associated with them. One of the most common pitfalls for business owners is treating the factor rate of an MCA like the interest rate of a traditional loan. This misconception can lead to paying far more than expected and potentially putting your business at financial risk.

How MCA Debt is Calculated

Merchant cash advance debt is calculated using something called a factor rate. The factor rate is a multiplier that represents the total repayment amount as a percentage of the cash advance. For example, if the factor rate is 1.4, and you receive an MCA of $10,000, you would owe $14,000 in total repayment.

Loan amount x factor rate = Repayment amount

$10,000 x 1.4 = $14,000

At first glance, that seems like a total loan cost of $4000.

Repayment amount – loan amount ≠ Total loan cost

$14,000 – $10,000 ≠ $4,000

But that’s not entirely correct. Merchant cash advances also include fees, which typically run about 10% of the original loan amount—$1,000 in this example. That fee comes out of the $10,000 the MCA company is advancing to you.

Loan amount – fees (~10% of loan amount) = Actual cash received

$10,000 – (0.10 x $10,000) = $9,000

So you actually receive $9000, not the $10,000 you requested. Therefore, your total loan cost is $5,000, not $4,000, as the math would suggest. Not exactly transparent, is it?

In exchange for that $9000, you will pay $5000 back over a short time period—much shorter than you would with a traditional loan. The fact that traditional loans are typically paid back over periods closer to 3-5 years means the monthly rate is much smaller compared to that of a Merchant Cash Advance, which frequently come with three- to six-month repayment timelines.

An Important Difference About Interest Based on Factor Rates

With a traditional loan, the interest rate determines how much interest you will pay on the remaining balance over time. This means that the amount of interest you pay diminishes from one payment to the next as the principal balance decreases.

The factor fees that determine MCA debt are different in that they are calculated only once using the original loan amount. The lender calculates all interest due and divides it evenly among your scheduled payments. Because the payment stays the same throughout the lifetime of the loan, you can’t save money by paying off your MCA debt early like you can with a term loan.

More problematic is that since the interest never goes down, you end up paying much more of it over time than you would with a traditional loan that uses APR. APR is the cost of your financing expressed as a yearly rate. It includes the amount and timing of the funding you receive, the interest and fees you pay, and the payments you make.

So, APR includes ALL fees and charges and the frequency of compounding. (Interest rate, on the other hand, does not include the frequency of compounding of any fees or charges).

1.4 Factor Rate ≠ 40% APR

If you mistook the loan cost for our example MCA to be $4000, you might also be tempted to assume a factor rate of 1.4 translates to a 40% APR.

$10,000 x 40% = $4,000

On the surface, the math makes that seem like a logical assumption. But remember, the real loan cost in our example MCA is $5000. And, in reality, a 40% APR doesn’t cost nearly $4,000 in interest.

The chart below compares a traditional loan with a 40% APR to an MCA at a 1.4 factor.

Chart showing amortization of a traditional loan versus MCA debt based on a factor rate

 

Due to amortization–the process by which the interest payment decreases in relation to the decreasing principal–a loan calculated with a 40% interest rate would actually result in a payback amount of $12,296, which is $1704 less than the payback amount for the MCA.

And that’s not all. Interest rates are calculated on an annual basis, and Merchant Cash Advances nearly always have shorter payback terms. So if the advance that you mistakenly believe has a 40% APR is due in six months, that “effective APR” is actually > 80%. If it’s due in three months, the “effective APR” is > 160%!

As you can see, assuming a factor rate of 1.4 is equivalent to an APR of 40% can prove to be a costly miscalculation.

The “effective APR” of your Merchant Cash Advance is a complicated calculation, but you can get close using the following formula:

Formula for calculating APR to better understand MCA debt

An APR calculation using our example to illustrate the high cost of MCA debt

So using the numbers from our example, we can see that MCA debt calculated at a 1.4 factor rate actually has an effective APR closer to 101%!

Impact on Cash Flow

Not only is the interest rate on MCA debt much higher than most people realize, MCA contracts stipulate that repayment is based on a percentage of daily/weekly credit card sales. This brings business owners comfort–business slumps come with smaller daily/weekly payment amounts, right?

Wrong.

While the payment amounts will often change from one payment to the next, Merchant Cash Advance contracts stipulate a minimum daily/weekly payback amount that the client personally guarantees whether they’re aware of it or not. So, for example, you might think your daily payback amount is 10% of your daily receivables–$100 of the $1000 you made today, let’s say. But the reality is, the MCA company is actually taking a flat rate of $500 (plus a percentage) every single day, no matter how much you sell.

Obviously, this can seriously impact your cash flow and make it hard to keep your head above water during slow seasons.

Get the Help You Need

When considering financing options for your business, choosing a borrowing product calculated using interest rates and APRs is in your best interest. Before you decide a Merchant Cash Advance is your last hope, it’s vital to understand how much you’ll actually be paying on that MCA debt and not assume the advance functions like a traditional loan.

If you find yourself facing unsupportable debt due to one or more Merchant Cash Advances, Rise Alliance can help. Our RISE Program is the ethical and transparent path to settling business debt and resolving personal guarantees. Schedule a consultation with one of our advisors today to learn more about how to protect your business’s financial health and future.

 

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