In the early 1990s, a new financing product called the merchant cash advance was introduced. It was similar in many ways to a term loan, but was structured as a sale of a specified percentage of a business's future credit card receipts.
This was a fairly innovative structure that meant the merchant only paid on the revenue that came in, which made merchant cash advances perfect for businesses with unstable cash flows. But this structure also had a fairly important consequence. Because it was legally a sale instead of a loan, it wasn't covered by the public and private regulatory regimes for commercial lending.
Savvy operators capitalized on this distinction to side-step state usury laws, even as they began to reshape merchant cash advances into what were effectively super high interest rate loans. They kept the idea of a specified percentage of future credit card receipts in theory, but in practice they replaced it with a fixed daily withdraw—only reverting to the specified percentage if the payment was missed. Some did away with credit card receipts entirely and structured it as a sale of future income or accounts.
Today, with a few notable exceptions, most merchant cash advances are almost indistinguishable from short-term daily payment loans, and most business owners don’t even consider the differences.
But here are six differences you need to know about merchant cash advances and how they differ from traditional loans.
1. They're Not Covered by Lending Laws
A fixed business term loan is covered by many regulations intended to protect the borrower. By contrast, a merchant cash advance isn’t considered a loan and so isn’t subject to those rules (that’s why the people peddling them are so careful to avoid the “L” word). Because of that, they can charge significantly higher interest rates in states like New York or Texas that would otherwise cap the rate. It’s much easier to stumble your way into a bad deal, requiring more diligence on your part to ensure that you can repay the advance successfully.
2. Impact on Your Credit Profile
A business term loan can be reported to credit agencies, and for sole proprietorships that information can even appear on your personal credit profile, as well as your business profile. A merchant cash advance is never reported to your credit profile and so won’t have any impact on your credit score.
While it can be tempting to view that as a purely good thing, remember that building your business credit history often relies on demonstrating good repayment history for loans and other borrowing methods, which a cash advance won’t provide.
3. Speed of Disbursement
Taking out a business loan can be arduous, with an extensive application process. In contrast, most merchant cash advances are structured to serve as emergency infusions of cash, so the entire process happens much quicker. In most cases, you can receive the funds within days of applying.
4. There's No “Interest” OR “APR”
Because it’s not a loan, it’s not accruing interest. Merchant cash advance companies probably wouldn’t be keen to tell you the APR anyway, since it’s typically double or triple digits. But even if they wanted to, they can’t—because there is no interest rate. But you can still figure out the effective APR using an APR calculator.
5. Prepayment Is a Pain
Because they’re a sale and not a loan, if you prepay them early, you don’t get a discount. All you’re doing is buying back your future income, which they’re not going to discount for you. In fact, more often that not, you aren’t allowed to buy back the future income at all. You’re forced to repay the merchant cash advance over its life.
(Note that this isn’t technically a prepayment “penalty,” since they’re simply not giving you a discount on the buyback. So if you ask “Are there prepayment penalties,” they can honestly say “No!”)
6. Ease and Speed
One area merchant cash advances excel is speed. Because they typically have APRs over 50%, there isn’t a lot of diligence required around repayment. An APR that high can cover over a multitude of problems, so they often offer same day or next day approval. That’s great if you need cash yesterday or you have poor credit, but you’ll end up paying for it.
Pro Tip: "Specified Percentage"
Notably, it’s important to watch out for your “specified percentage” or “holdback percentage.” Most business owners assume that’s the interest rate, but those terms actually define the percentage of your business revenue that must be used for repayment. For example, a holdback percentage of 20 percent means you’ll need to pay 20 percent of your total cash revenue each day or each week, depending on your repayment terms.