Factor Rates vs APRs and How to Pick the Right Option

Posted at 04:52h in Small Business Financing by Kelly Hillock

Factor rates and APRs (annual percentage rates) are similar in that they both measure the cost of borrowing money, but they are different because factor rates calculate the total payback amount versus APRs that tell you how much you pay back each year in interest plus fees. They’re also different on taxes, where businesses deduct factor rates as an operating expense and APRs include both fees deducted as operating costs and interest payments deducted as interest expenses.

Lenders use APRs for most loans since the concept of a yearly rate is familiar to most people. Merchant cash advances (MCAs), invoice factoring, and some short-term business loans use factor rates when the total amount being repaid is more important than an annual percentage. This could be because the loan gets repaid in less than a year or because repayment amounts can vary widely over the payback period.

Businesses pay back MCAs as a percentage of daily sales, so it’s practically impossible to figure out an APR in advance without knowing how much each future day’s sales will be. So, you’ll see factors rates instead. Factor rates are also used for invoice factoring since it’s technically an asset sale and not a loan.

The total payback amount with factor rates is calculated with this formula:

Payback amount = Amount Borrowed * Factor Rate.

This means if you borrowed $100,000 with a factor rate of 1.1, you’d pay back $110,000. Be mindful of how fees are treated though because sometimes they’re included in the factor rate while other times they’re deducted from your borrowed amount. If the lender charges a 1% origination fee and deducts it from your loan, you’ll still repay $110,000 but only receive $99,000 ($100,000 amount borrowed minus the 1% origination fee).

Lenders use APRs on longer-term loans to let you know how much your loan will cost each year, including interest and fees. Since the APR includes all fees, it’s usually different from the interest rate on a loan. These are the 2 steps to calculate your APR:

First, calculate the interest expense.

For a 1-year loan of $100,000 with simple interest of 15%, your interest expense is $15,000 = 15% * $100,000.

Next, use this formula to calculate APR:

APR = ((Interest Expense + Total Fees) / Principal) / Number of days in the loan term) * 365.

If your total fees were $1,000, the APR would be 16% = (($15,000 + $1,000) / $100,000 / 365) *365.

Figuring out whether a factor rate or APR-based loan is better for your business depends on your ability to qualify for financing, how quickly you need the money, and how quickly you can pay it back.

Situations for Factor Rate Based Loans over APR

Factor rate-based loans are better than APR priced loans in situations where you can’t qualify for a traditional small business loan, when you need flexibility in how much you pay back each month, or when the factor rate costs less than the APR.

Businesses with a poor or unstable financial history likely will not get approved by traditional lenders that require 2 to 3 years of consistent financial statements that prove a borrower is low risk. Alternative lenders may offer MCAs and other short-term financing based on factor rates.

Since the factor rate determines how much you pay back in total, you can negotiate flexible payment terms with lenders for when your cash flows fluctuate. Seasonal summer businesses can use a factor rate cash advance of $100,000 to stock up on inventory in April and then repay the loan like this as the season builds and ends:

Month	Payback Amount
May	$5,000
June	$10,000
July	$30,000
August	$35,000
September	$15,000
October	$5,000

APR based loans would make them pay back equal amounts each month even if cash flow from sales wasn’t high enough in the early months.

If your business can qualify for both types of funding and cash flows are stable, then choosing a factor rate loan comes down to whether it’s cheaper than an APR based loan. There are 2 ways to compare loans:

Convert factor rate to APR to compare annual rates.

Compare exact costs.

Convert Factor Rate to APR

You typically repay factor rate loans in under a year, but they can have longer terms as well, so use this formula to figure out the APR equivalent for factor rate loans:

Factor rate “APR” = ((Payback Amount – Amount Borrowed + Fees) * 365 / Days to Pay Back) / Amount Borrowed.

Using the earlier example, assuming you borrowed the money April 1 and paid off the debt on October 31, your factor rate APR equivalent = (($110,000 – $100,000 + $1000) * 365 / 214) / $100,000 = 18.8%.

On an annual basis, the factor rate loan looks more expensive than the 16% APR loan from earlier. But because you repaid the loan in only 214 days instead of 365, the true cost of the loans will be different, and you should compare exact costs.

Compare Exact Costs

Comparing exact costs of factor rate vs APR loans means adding up the total expenses of each no matter how long the terms were. The total cost of the factor loan was $11,000 ($10,000 from the factor rate and $1,000 origination), but the total cost of the APR loan earlier was $16,000 ($15,000 interest expense and $1,000 origination). In this situation, the factor rate loan is $5,000 cheaper even though its equivalent APR is higher.

Times to Choose APR Based Business Loans

APR based loans are better when you can fit the monthly payment into your budget, and the total cost of the loan is cheaper than a factor rate loan. Consider the same process from the previous section, but use a factor rate of 1.2 instead of 1.1 for this example:

The $100,000 APR based loan costs $16,000 for a 16% APR.

Using the new 1.2 factor rate means your total factor rate loan payback would be $120,000, and the loan would cost $21,000 (factor rate fee + origination fee).

The APR based loan is $5,000 cheaper, and you’d only choose the factor rate loan if there was a risk you couldn’t make consistent monthly payments on the APR loan. If the summer seasonal business mentioned earlier had cash flow to cover monthly payments even during the off-season low months, then it makes more sense to choose APR based funding.

Pro-tip: If the APR loan terms do not include curtailment penalties, use higher than expected summer sales to pay off the APR based business loan early and save money by avoiding future interest expense.

Factor rates and APRs both measure the cost of borrowing money, but they measure it differently. Factor rates tell you the total amount you must repay, while APRs tell you the annual cost as a percentage of the total amount you borrow. Choosing the right one comes down to your ability to qualify, whether lenders offer both options or just one, and which one costs less in total.

QuickBridge does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only. You should consult your own tax, legal, and accounting advisors.