Successfully running a small business requires a steady stream of working capital. Loans can provide the financing you need when cash reserves run low or you’ve earmarked your cash for another purpose. A loan’s annual percentage rate, or APR, determines the cost of borrowing for some loans, but others use a factor rate instead.
APR is the interest rate on a loan in annualized form. It’s the total cost of borrowing for one year, when the interest rate and loan fees are added in, expressed as a percentage. A factor rate is expressed as a decimal and usually ranges from 1.1 to 1.5. The factor rate can be used instead of an APR to determine the total amount you’ll need to repay.
What Types of Business Loans Charge an APR?
You may be more likely to pay an APR for small business financing with certain types of loans than others.
“APR applies most often to term loans, Small Business Administration loans, business lines of credit and credit cards – traditional bank credit products,” says Jay DesMarteau, head of regional commercial specialty segments at TD Bank.
APR can also be associated with business term loans or lines of credit offered by lenders other than banks. That includes online and peer-to-peer lenders.
When You May Pay a Factor Rate Instead of an APR
Factor rates may apply to specific types of business financing that don’t fit the typical loan mold, usually short-term financing.
A merchant cash advance may utilize a factor rate rather than an APR to determine cost. An MCA is an advance against your business’s future credit card receipts.
How to Calculate Factor Rate vs. APR
The factor rate you pay may be based on how much you’re borrowing and your repayment terms, as well as your time in business, average monthly sales and the consistency and frequency of revenues. The higher the factor rate, the higher the total repayment, excluding fees.
Determining the total repayment amount for a factor loan is fairly simple. You multiply the loan amount by the factor rate. Say you’re borrowing $10,000 with a factor rate of 1.2 for a 12-month term. Your total repayment would come to $12,000 ($10,000 x 1.2).
In terms of how that translates to an APR, you might assume that you’d be paying 20 percent ($10,000 x .20 = $2,000), but that’s not exactly accurate. While the interest rate is 20 percent, the actual APR may be higher since APR depends on the loan amount and repayment term, how often you make payments (daily, weekly or monthly), the factor rate and any additional fees the lender charges.
“The specific repayment frequency and how the lender chooses to calculate finance charges can have an impact on the APR,” says Kenneth Freije, vice president, head of credit risk at short-term financing company Behalf. Additionally, “a business’s creditworthiness, the length of the time the business is looking to borrow funds, the size of the financing instrument and any additional fees can all impact the APR.”
Using the $10,000 example, assume you take 12 months to repay the loan with a factor rate of 1.2. You make payments monthly. That works out to an effective APR of 35.07 percent when the interest and fees are calculated on an annualized basis.
Though some business term loans have APRs that range to about 36 percent or higher, your business may qualify for a lower rate, as term loan APRs can be as low as 3 percent.
Is APR or Factor Rate Better for Small Business Loans?
The type of loan you take out will determine whether your loan is subject to an APR or a factor rate. The answer to this question depends on several things, including:
- How much you need to borrow.
- How quickly you need to receive financing.
- Your personal and business credit history.
- Your time in business and revenues.
- How much you’re willing to pay for a business loan.
- Whether your need for capital outweighs cost.
From an approval perspective, business financing that uses a factor rate, such as a merchant cash advance, may be easier to qualify for.
With these types of financing, your future invoices effectively serve as collateral to secure the loan. A low personal or business credit score or a shorter time in business may not necessarily be an obstacle to getting financing. Getting a more traditional business loan from a bank or through the SBA, on the other hand, may entail meeting more stringent credit or time in business requirements.
Funding may also be faster with factoring options, such as a merchant advance. Depending on the financing company, you may be able to get funding in as little as 24 hours. Some online lenders can fund business loans and lines of credit in just a few business days, but with a bank loan, you may be waiting weeks for funding to be finalized.
There are some downsides to choosing a loan with a factor rate instead of an APR, however.
Factor rate financing may give you less time to repay what you borrow. For example, you might be expected to repay a merchant cash advance within 18 months, while loan repayment could be stretched over three to five years or longer when you borrow from a bank or online lender. That could put less of a strain on your monthly cash flow.
Perhaps most importantly, business owners need to consider the cost of getting a business loan with an APR versus the cost of factoring. Ultimately, you may have to decide what’s most important: being able to access capital quickly with minimal obstacles to approval or getting financing at the lowest possible cost.
A Checklist for Small Business Financing
If you’re considering any type of small business loan, whether it’s short-term financing with an accounts receivable loan or merchant cash advance, or a more traditional loan, it’s important to be prepared.
- Check your personal and business credit report and scores. A quick credit check can give you an idea of which type of business financing you’re most likely to qualify for.
- Run key financial statements for your business. Lenders may expect to see a cash flow statement or a profit and loss statement, and having these documents prepared beforehand can save time when you’re ready to apply.
- Assess your business financing needs and budget. Ideally, you don’t want to borrow more than your business needs or more than you can reasonably afford to repay.
- Review and update your business plan, since lenders may ask to see a copy as part of the loan approval process.
- Review lender guidelines for time in business and revenues. Similar to checking your credit, this can help you weed out loans you may have a harder time getting approved for.
- Consider what you’ll offer for collateral if the lender requires it to secure the loan.
These tips can make the process of choosing and applying for small business loans easier. Most importantly, do the math on a loan before you commit.
“Business owners need to think about the cost over the life of the loan,” TD Bank’s DesMarteau says. They “should make sure to compare the annual cost of each product before executing on one.”