Merchant cash advance can be an alternative to a business loan

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Ask a Lender
September 20, 2017


Key Points

Basics of merchant cash advances

  • Not considered loans
  • Funded by business credit card receipts
  • Repayment pegged to sales levels
  • Cost of money fixed, regardless of payback period
  • A costly source of funds

If your business does a lot of credit- or debit-card sales, and you have trouble landing a business loan, you might find yourself considering a merchant cash advance (MCA).

MCAs are relatively easy to get, as long as you can demonstrate that you have sufficient credit- and debit-card cash flow. Consequently, MCAs are most commonly used by retail business and restaurants. Like other alternatives to business loans, however, they are an expensive source of funds.

In addition to cost, there are differences between MCAs and business loans. For starters, MCAs are not considered loans, but rather are deemed cash advances. That means as you pay back the cash advance, your credit rating does not reflect your successful handling of debt. On the other hand, you do not have to list MCAs as debt if you're applying for credit — although they are an expense that a prospective lender would be interested in knowing about and might affect a loan-application review.

With MCAs, instead of paying a traditional interest rate, you pay what is called a factor rate. To arrive at the amount you need to pay back, you multiply the amount of money you're advanced by the factor rate. If you borrow $20,000, for instance, at a factor rate of 1.3, you will owe $26,000. The factor rate can vary a lot, but factor rates of 1.2 to 1.4 are common.

To repay the money plus the factor rate, you agree to provide the MCA provider with a certain percentage of the money collected from future credit- and debit-card transactions, called a holdback. Usually, the holdback is between 5 percent and 20 percent of collections.

Also, unlike a loan, the length of time covered by the transaction is not set. Instead, the holdback on your credit- or debit-card receipts continues until you have repaid the entire amount you owe. For instance, if you agree to a 10 percent holdback on total credit- and debit-card transactions, and those transactions total $260,000 per year (for the sake of simplicity), you will have paid back the advance in one year — and most MCAs are structured to be repaid in a year or less.

In addition, there's no advantage to paying back the MCA early. The amount you owe is based on the factor rate only and not on interest payments that vary according to the amount of a loan's principal that is outstanding. 

In fact, because the fees are fixed regardless of how soon the money is paid back, the faster you repay the amount owed, the higher the effective cost of MCA transaction. If you're paying a factor rate of 1.4 and pay back the money in just a few months, for example, you could be paying the equivalent of a triple-digit interest rate. If you're in the market for an MCA, also pay close attention to the fees the provider charges for setting up or administering the advance and repayment. Those fees can be much higher than typical bank loan fees.

With all those caveats in mind, MCAs may make sense for some businesses that lack access to cheaper credit. A 2015 survey by the Federal Reserve Bank of New York showed that 7 percent of small businesses had applied for MCAs, and that the figure rose to 10 percent among businesses with annual revenue of less than $100,000.

MCAs are an unsecured source of funds, so you do not have to put up business equipment, your house or a cash down payment as collateral. The MCA provider will usually not be interested in your personal financial statements or credit history, but will want solid documentation of your business financials, including bank and credit card statements, to assure that there is enough money coming in the door to repay the MCA.

The structure of MCAs can be advantageous for a business whose sales vary significantly from month to month. Because the repayment schedule is based on a percentage of total credit- and debit-card sales, when sales decrease so does the amount of the holdback payment.

As with all short-term funding, MCAs are best used for short-term needs, such as covering routine seasonal slowdowns or other types of anticipated cash-flow problems. They are typically not used for funding capital improvements or property and other large purchases.

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