Small business owners researching the best loans for small businesses (be it in the form of a business loan, merchant cash advance, or credit card) have likely come across three ways to express the cost of a loan:
- annual percentage rate (APR),
- interest rate,
- and factor rate.
As though finance weren’t complicated enough–
The truth is, each is a totally different type of interest rate; they are all calculated differently, and thus have very distinctive meanings.
To simply ask “What is interest rate versus APR?” is to risk not fully understanding the true cost of financing.
Comparing interest rate to APR is like comparing apples and oranges– and if we stick with the fruit metaphor, that makes the factor rate something like bananas.
We strongly encourage small business owners considering a loan to study the explanations in this article before deciding on a type of business financing.
APR and interest rate are more closely related than either is with factor rate, so we’ll discuss those two first before describing how a factor rate might come into play.
What is an APR vs. interest rate?
The interest rate is the annual cost of a loan to a borrower expressed as a percentage of the principal loan amount.
Easy enough so far.
Whether your business loan uses simple interest or compound interest, these rates disclude any other fees associated with a business loan (such as origination fees, closing fees, documentation fees, discount points, etc.)
Banks and other lenders will often discuss their rates in terms of the interest rate due to its simplicity (and the fact that it’s a lower number than the APR.)
Comparing interest rates between various loans can work as a helpful shorthand when deciding which lender to go with, but keep in mind that interest rate doesn’t tell the whole story.
Here’s where APR comes in:
The APR, or annual percentage rate, is the interest rate of a loan plus any additional fees (also expressed as a percentage.)
Since the APR includes fees, it’s often referred to as “true cost of the loan.”
The Wall Street Journal compares APR to the energy-efficiency rating for a refrigerator, giving borrowers a way to measure what “the lifetime cost of what the loan is likely to be.”
The inclusion of these fees makes a big difference, usually resulting in an APR between a quarter and half a point higher than the interest rate—
So it won’t serve you well to compare the interest rate of one loan to the APR of another.
But don’t worry, lenders can’t try to get one over on you by passing off the interest rate as the true rate.
The Federal Truth in Lending Act requires that consumer loan agreements always reveal the APR.
In the world of finance, most would agree that APR is the single best point of comparison between loans.
Should I use interest rate or APR to price my loan?
Technically, you should use both rates when comparing different loans.
While the APR is the true cost of the loan, with every fee taken into consideration, the interest rate is what you’ll have to worry about on a month-to-month basis.
Basically, you’ll want to know both for the express purpose of ensuring you have all the information possible before making a decision—
And to make sure you’re not comparing an apple to an orange.
Because this isn’t fruit:
This is your business at stake here!
If for some reason you aren’t given an APR, but instead provided with an interest rate and a list of fees you’ll need to pay, there are ways to calculate APR yourself.
Spreadsheet apps such as Google Spreadsheets have the formulas ready for you to use, or you can visit an APR calculator site to crunch the numbers.
And that just leaves us with invoice factoring and merchant cash advance factor fees…
Factoring: Understanding invoice financing factor rates & merchant cash advance factor fees
Factor rates or factor fees are used when applying for alternative financing like a business cash advance or invoice financing.
Unlike APR or interest rate, factor rates can be displayed as decimals or percentages.
- Factor fees associated with invoice financing are generally expressed as 3% + % / week outstanding
- Factor rates associated with MCAs are generally expressed as 1.14 – 1.18
To best understand a factor rate, you’ll need to know what makes invoice financing and merchant cash advances different from other types of business loans and credit.
What is a merchant cash advance?
An MCA is a financing tool where your business can borrow a cash advance from the lender against future credit card sales and pay back the lender with a portion of each transaction.
With an MCA, daily or weekly payments fluctuate depending on your sales for that period, which is why it’s easier to express cost with a factor rate.
Sometimes known as buy rate, this is the rate you’ll be charged on the amount you borrowed.
There are a few reasons why someone might go with an MCA to obtain credit:
- Higher approval rates: All you (usually) need is a track record of debit/credit card receivables to be eligible for an MCA.
- No collateral necessary: MCAs don’t require putting your assets, such as your business or home, on the line as collateral.
- No fixed payback schedule: With a loan, you owe your monthly scheduled amount regardless of how business is going. With an MCA, you pay back the borrower with each sale— so if business is slow, your repayment is slow.
On the other hand, it’s not all sunshine with MCAs either–
Merchant cash advances are typically the most expensive form of business financing product on the market.
Converting MCA factor rate to APR:
For a business cash advance of $10,000 with a factor rate of 1.18, you can calculate effective APR at about 104.66%.
With factor rates, all of the interest is charged to the principal when the MCA is originated.
This means factor rates are calculated only once, while interest rates are calculated multiple times and are based on depreciating capital.
You essentially pay all of your interest upfront.
This is probably why MCAs are markedly less popular than loans:
A Federal Reserve Bank of New York study found that more than half of respondents had either used a loan or line of credit before, while only 7% said they’d used an MCA.
What is accounts receivable financing? (aka invoice financing)
Accounts receivables financing companies advance your business cash using outstanding invoices as collateral.
With invoice financing, you could get a fast advance of about 85% of your total accounts receivable with most of the other 15% paid to you later.
It’s actually a perfect solution for dealing with slow paying customers or cash flow issues.
The remaining 15% gets held in reserve and subjected to fees until your customer pays their invoice off.
From that 15%, the financing company first deducts a processing fee— often around 3%. They’ll then charge a “factor fee” that is calculated based on how long it takes for your customer to pay up (usually compounded weekly.)
For example, many lenders charge 1% each week until payment.
Eventually you should receive that extra 15% minus fees— that’s the price you’re choosing to pay for cash now instead of whenever the customer can complete your invoice.
What are the similarities between interest rate, APR and factor rate?
As you can see, interest rates, annual percentage rates, and factor rates mean different things.
But there are some similarities in the way they are calculated.
In every situation, the lender will review certain characteristics of your business to decide what kind of interest rate or factor rate to charge you, including:
- Business bank statements and tax returns
- Years in business
- General health of the business, which includes credit card processing statements (especially helpful for factoring finance options)
- Current borrowing ratio (meaning how much you are already borrowing from other lenders)
- The type of loan you’re looking to obtain
Generally, if your business is in good standing and your lender considers you a low-risk to lend to, you’ll receive a low interest rate or factor rate (and thus, a lower overall APR.)
If you are considered high-risk (maybe due to your industry or your credit history) you’ll likely pay a higher rate all around.
Note: If you end up with a higher rate than you’d like, it’s sometimes possible to negotiate new terms with your lender after demonstrating your willingness to pay on time.
What types of business loans are there?
- Business Credit Cards
- Short Term Business Loan
- Term Loans
- Business Line of Credit
- Equipment Financing
- Merchant Cash Advance
- Invoice Financing
- SBA Loan
- Personal Loans for Business
Sounds like this is your first time taking out a loan for your small business.
You should shop around for a loan to get the best deal, don’t you think?