# How are cash advance rates calculated?

By ,
September 20, 2017

#### Key Points

• A cash advance is not a loan, but a purchase of future sales revenue.
• Costs are determined by a factor rate instead of an annual percentage rate.
• Cash advances are far more expensive than conventional loans or lines of credit.

The benefit of a cash advance for your business boils down to the factor rate. Many small businesses that struggle to obtain financing from conventional lenders look to cash advances as a means of getting quick capital. Yet advances can be far costlier than they initially appear and can put your business in danger of going further into debt if you do not have a solid understanding of how their rates are calculated.

A cash advance is a commercial transaction where a company purchases a percentage of a business’s future sales revenue, minus fees. The revenue can be a portion of credit- and debit-card sales — called a merchant cash advance — or come from checks or deposits. This should not be confused with payday loans, which are used by consumers for personal reasons.

Cash advances are easy to obtain even for businesses with low credit, existing liens or past penalties for non-sufficient funds. However, this ease comes at a price. Cash advances can be one of the most expensive financing options, with interest rates often reaching triple digits.

In addition, a cash advance is not technically a loan, so cash advance providers are not governed by banking regulations that require lenders to provide an annual percentage rate (APR) for every loan product. Instead, providers use different calculations and terminology than conventional loans, making it difficult to compare their products to business loans and lines of credit.

Cash advance companies use their own terms — called a factor rate, or a buy rate — to disclose the cost of the advance. Factor rates typically range between 1 and 1.5, and are multiplied by the advance amount to derive the borrower’s total repayment amount. A \$15,000 loan with a factor rate of 1.4, for example, will cost \$6,000 (15,000 x 1.4 – 15,000), meaning the total amount needed to repay the cash advance is \$21,000.

This factor rate of 1.4 may sound like an annual interest rate of 40 percent, assuming the loan is paid back in a year. APR, however, calculates interest only on the outstanding balance of a loan, which diminishes over the course of the term, ultimately decreasing the cost of the interest. With a factor rate, interest is charged on the entire principal amount throughout the entire term of the loan. Assuming the business receiving the cash advance promises to pay 15 percent of their monthly sales of \$10,000 per month until this \$21,000 advance gets repaid, the associated APR of that advance would be 62.07 percent.

A company that can demonstrate at least three months of consistent profitability and surpasses the cash advance provider’s minimum monthly sales requirement will almost certainly qualify for a cash advance. Factor rates, however, are determined based on a company’s ability to pay back the advance — much like interest rates — so high-risk businesses with poor credit or existing liens will typically face higher factor rates. Companies that have been in business for less than two years or those with no established history of credit may also have to pay a higher rate.

#### Cost comparisons

When calculated as an APR, the cost of cash advances far exceeds any other type of business financing on the market. The U.S. Small Business Administration (SBA) offers loan programs with interest rates ranging from prime plus 2.25 percent to prime plus 6 percent (for most programs as of May 2017), while conventional secured business loans can have interest rates as low as 4 percent to 6 percent and unsecured loans can range from 6 percent to 23 percent.

Business lines of credit have variable interest rates that are typically tied to the prime rate, but can be as low as prime plus 1 percent to 1.75 percent. Even nontraditional unsecured business lines of credit — such as business credit cards — carry more competitive rates than cash advances. These are typically under 20 percent and often have a zero-interest introductory period.

Before opting for a cash advance for your business needs, check if you qualify for a conventional loan or line of credit. Alternatively, if your business holds outstanding invoices, you may consider selling them to an invoice factoring company for quick cash, which could potentially be cheaper than a cash advance.

There are situations when cash advances are worth exploring. They might make sense, for example, if you have a new, yet steadily profitable, business that cannot obtain conventional financing for a one-time expense. The high cost and strict repayment conditions can significantly stymie day-to-day cash flow, however, so take care to compare cash advance providers and rates at an APR level. Understand exactly how much that advance will cost your business and ensure that repayment will not push you further into debt.