When traditional small-business loans are too difficult to acquire and you can't raise the capital you need through investors, many small business owners seek funding through a merchant cash advance (MCA).
But an MCA is a fairly complex financial instrument, with a lot of variations on the market. So what is an MCA, and how does it work?
What Is a Merchant Cash Advance?
Very technically, a merchant cash advance is an advance payment given to you by a merchant advance provider in exchange for a share of your future credit/debit card sales. You continue to make these payments until the merchant cash advance is paid back in full, along with any interest or other fees as dictated by the MCA provider.
A traditional MCA provider will usually be partnered with your merchant account provider (or be a merchant processor itself!) so as to be able to receive payments automatically.
More generally, the term MCA also encompasses any advance given in return for a specified percentage of your future income, whether repaid by card receipts or not. It even encompasses advances given with the expectation of a fixed daily repayment.
Merchant advance providers determine how much you are eligible to borrow based on the total sales of the previous few months. The more you initially borrow, the more you will be required to pay back each day. This is referred to as the factor rate.
What Is the Factor Rate?
A factor rate differs from the interest rate associated with traditional loans in that you aren't necessarily paying back the loan with interest, but rather making payments based on the total amount of the loan multiplied by a certain factor.
For example, let's say you borrow $10,000 at a factor rate of 1.5. Multiply 10,000 by 1.5 and you get 15,000. Assuming that the terms of the advance include that you will pay it back in 90 days, divide 15,000 by 90, and you get $166.66. That would be the amount you need to pay back each day, for 90 days.
What Determines a Factor Rate?
The variables that will determine your factor rate include the following:
- How much you make in daily and monthly sales
- How long you have been in business
- How much you are seeking to borrow
- The nature of your industry
- The amount the MCA provider wants to earn
It is important to fully understand how the factor rate works, because you can be easily misled into thinking that your payback rate will be less than it actually is. An APR is typically easy to figure, but a factor rate and the associated payback rate are not as clear. Your payback rate can include additional fees that aren't always disclosed upfront, such as financing fees that must be prepaid or added to the daily payback rate. This can greatly increase your APR.
Additionally, merchant cash advances typically have shorter payback periods, which essentially means you will be paying a higher APR. Daily or weekly payments also increase your APR, as the interest is charged over a shorter period of time.
Pro Tip: Calculate the True Cost of Your Merchant Cash Advance
If you are considering a merchant cash advance and have already spoken with a provider, use the Able true rate calculator to discover the true rate of your MCA and decide whether it is a viable deal or not.
You will also want to be aware of your specified percentage. A specified percentage differs from an interest rate as well, as it refers to the percentage of your revenue you must pay each day or week, depending on the terms of your advance.
The Difference Between a Merchant Cash Advance and a Traditional Small-Business Loan
As you can see, an MCA can be an expensive way to get a quick loan, and there are other important differences between MCAs and traditional loans offered by banks and financial institutions.
- MCAs often have prepayments of financing fees, and your APR can be much higher than that of a traditional loan.
- MCAs are not covered by lending laws, so merchant cash advance companies can charge an extremely high factor rate, and you, as the borrower, are not as protected from a bad deal as you might be with a traditional loan.
Pros and Cons of Merchant Cash Advances
- MCAs don't have any effect on your credit score
- You can get an MCA very fast and very easily
- More flexibility with payments (for traditional MCAs, at least)
- Prepayments typically don't give you any benefits, just more cost and headache
- MCAs can be very expensive to pay back
- Payback terms are often very short, and can cause daily cash flow problems
- Traditional lenders dislike MCAs, and may not wish to provide you with a loan in the future because they view you as more likely to take out more in the future
If you aren't sure a merchant cash advance is right for you, there are still other options.
These include a business line of credit, which can be fairly easy to get and typically has a much lower interest rate, and a term loan, which can take longer to get, but also has the benefit of very low interest rates.
Be sure to get all the details regarding any type of loan or merchant cash advance you may be considering, so as to make the best decision possible for your company's future.