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Factor rates vs. interest rates? What’s the difference? Financing language can be a little much. Luckily, understanding the differences and doing the math is easier than you think. In contrast with traditional interest rates, factor rates offer a simple and straightforward approach to calculating the cost of borrowing.
“It’s become more crucial for businesses to understand their financing options, and that includes mastering the terms used for pricing and understanding what numbers matter most,” said Credibly Founder Ryan Rosett.
In this guide, we’ll get into factor rates, exploring their nuances, benefits, and how they compare to other rate types.
Credibly Founder & Co-CEO Ryan Rosett along with other members of the @ForbesCouncils shared advice on what #entrepreneurs should consider before taking out a personal loan to fund their business. https://t.co/QzH0d5vwFr #lending #personalloans #funding #smallbusiness pic.twitter.com/l6ztIemfoA
— Credibly (@credibly360) January 2, 2020
What is a factor rate?
With all the financial terminology you’re hearing as you assess the options for your business, you might be a bit puzzled when it comes to factor rates. Simply put, a factor rate is a way to determine how much a loan will cost you.
This kind of cost estimation is more likely to be found on alternative forms of business financing, like short-term business loans, merchant cash advances, business lines of credit or invoice factoring.
Here’s a simple rundown on how factor rate works for a loan: It’s your total payback amount divided by your loan amount and it’s usually written as a decimal number.
Factor rate = Total payback amount / loan amount
If you are only given your loan amount and factor rate and not your total payback amount, it’s easy to figure out that payback amount.
Let’s assume you get a $10,000 loan and you’re given a factor rate of 1.3. This means you’d pay back $1.30 for every $1.00 you borrowed (in other words, 30 cents on the dollar). To get the total amount you’d repay, you’d multiply the loan amount by the factor rate.
$10,000 x 1.3 = $13,000.
This means you’d repay $13,000 over the term of the agreement. (Just remember that there may be other fees in the loan agreement and those are not included in the factor rate or the total payback amount.)
Why businesses should want use factor rates:
Factor rates are easy to work with—they provide businesses a clear picture of their financial commitment right from the start.
With factor rates, businesses can skip out on complex calculations like figuring out how much interest might be added depending on how long the loan term is or how much of the outstanding loan principal has been paid. Businesses can also easily compare the cost of each financing option based on how much they are getting and how much they will owe.
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Factor rates vs. interest rates: What’s the difference?
As we’ve already gone into what a factor rate is and how to calculate it, let’s take a look at the key difference between that and interest rates.
Unlike factor rates, interest rates are often expressed as a percentage, representing the annualized cost of borrowing money. However, if your loan is longer or shorter than one year, it is not always easy to figure out the true cost of the loan in real dollars. An interest rate also does not include other fees or costs associated with a loan – those costs and fees are included in another “rate” term you may have heard: Annual Percentage Rate (APR).
The calculation of interest rate can be complex, and you’ll need other important information like the term of the loan, how often you are making payments, and whether the loan is simple interest or compound interest. Neither interest rate nor APR will provide a quick answer for the total amount you will owe or give the easy-to-understand information regarding how much each borrowed dollar will cost you.
As a reminder, costs and fees are not included in interest rates or factor rates. Only APR includes those in its calculation. You’ll need to look in the loan agreement to see the actual amounts). However, it is quick and easy to add those costs and fees to the total repayment amount you have calculated with the factor rate and understand your total obligation under your loan agreement.
Overall, the differences lie in:
- Calculation basis: Factor rates are an opportunity for businesses to see the straightforward total cost of borrowing as well as the cost of each dollar borrowed. In contrast, interest rates can be confusing. They are periodic and often annualized, and depend on whether they are simple or compound interest, how often you are making principal payments, and whether they amortize.
- Usage: If you’re looking at alternative financing for your business, you’re likely to see factor rates more often. Interest rates, on the other hand, are standard in traditional, longer-term loans.
- Transparency: Your factor rate provides immediate clarity on cost and total repayment, while interest rates, especially when amortized, require more intricate calculations to determine how much you’ll ultimately end up paying.
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How lenders set your factor rate
If you decide to work with an alternative lender, these are some of the factors that may impact how they set your factor rate:
- Risk assessment: Alternative lenders use sophisticated algorithms and data analytics to assess your creditworthiness as a business borrower. This assessment may include analyzing business revenue, cash flow patterns, industry type, how long you’ve been in business, and also your personal credit as the owner or principal.
- Loan duration: If you’re looking at a short-term loan, you’ve likely seen higher factor rates. Lenders want to make sure they’re compensated for the risk they’re taking, especially when the repayment window is short.
- Operational costs: Often, alternative lenders have a more streamlined, digital-first approach, but still do take on costs. These are factored into the rate.
- Market dynamics: The condition of the economy, industry trends, and the competitive landscape all play a role in determining your factor rate.
Which loans and other financing products use factor rates?
As we’ve already mentioned, broadly speaking, factor rates are more often used by alternative lenders. But here are some of the loans and financial options that use factor rates:
- Merchant cash advances (MCA): A sale of a specified amount of future sales receivables (usually credit and debit card sales). The business is paid in upfront, lump sum and then the future sales receivables are remitted as a specified percentage of a business’s daily or weekly sales until the total purchased amount has been given.
- Invoice factoring: Sell your outstanding invoices to a third party (a factor) at a discount. That third party then collects payment on those invoices from the business’s customers.
- Short-term business loans: Business loans that typically have terms of less than a year and often use factor rates instead of annual interest rates.
- Business lines of credit: Gives a business access to a certain amount of capital when they need it. When principal is repaid, that amount can become available again in the future for borrowing.
- Equipment financing: Specific financing tied to buying or leasing equipment to help your business get the tools you need.
Unlock your business potential with Credibly
Weighing your financial options can feel overwhelming. Factor rates, interest rates, APR—it’s a lot to digest. But with Credibly, you’ve got financing experts on your side.
We’ve worked with over 30,000 businesses, and we take pride in providing entrepreneurs with the insights and financing they need to thrive.
Take the next step with Credibly. Speak with a financing expert today.
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