How do merchant cash advances work, and what if my business can’t repay?

When traditional banks say no, small business owners are turning to alternative lenders who are all over the Internet. The ads sound really appealing: cash fast without all that bank hassle. But dig a little deeper and they turn out to be payday loans for businesses.

An MCA Is a Commercial Transaction

Merchant cash advances (also called an MCA) may sound like short-term loans, but they’re not loans by any legal definition. What’s the same is you get money and you pay it back. Many owners sign these contracts without fully understanding the terms. Not reading the small print can be costly.

Because it’s a commercial transaction, an MCA is not covered by the federal Truth in Lending Act. The provider gives you a lump sum in exchange for a share of your future sales or receivables, or set bank withdrawals, plus fees.

While these deals are quick, they’re some of the most expensive ways to get cash. Annual percentage rates for cash advances can run as high as 300 percent to 400 percent.

Don’t expect to be told important information. In most states MCA providers have no legal duty to volunteer key details. They don’t have to tell you your annual percentage rate (APR) or explain how much more than the advance you’ll repay in total. They don’t have to describe the legal or financial consequences of defaulting on a contract.

The contracts are confusing. Even a trained expert can have trouble calculating how much you will actually pay under the terms of the contract you sign.

What you could risk depends on the contract. You’ll have little control over how your debt gets paid. And even if you repay faithfully and build a good payment history, that will have no impact on your credit score.

Many conventional bank loans are subject to state usury laws that cap interest rates, but MCAs are not. That can spell confusion and unexpected debt. Some MCA companies have misrepresented how their fees and rates are calculated.

You may learn too late that you can’t save money by paying an advance off early. You still owe every dime of the fees and interest.

Payment Schedules

The repayment terms for an MCA typically run from three to 18 months. Some MCAs take a share of your credit and debit card sales every day or week until you pay off the advance and any fees due. Others withdraw a fixed sum from your bank account every day or week no matter what your sales. If cash flow is already tight, a fixed payment schedule can make it worse.

These deals also calculate their costs differently than a regular loan. Instead of an annual percentage rate, you get a number known as a “factor rate.” It’s usually between 1.1 and 1.5. It depends on factors like your type of business, how long you’ve been in business, your total revenue, your personal credit score and number of credit and debit card sales. Risky businesses get charged higher factor rates.

To find the total amount you’ll repay, multiply the amount of the advance by the factor rate. So a business that takes a $100,000 advance at a factor rate of 1.3 will repay a total of $130,000.

That’s a total of $30,000 in addition to the cash advance. That sum is a heavy burden to owe and you have to pay it back within months. That doesn’t count any administrative, underwriting or other fees. The extra fees on top of the factor amount can be large too.

It can get hard to make payroll and other expenses if sales are slow. Some owners take out another advance to pay off the first one. That can get a small business trapped in a cycle of debt.

You Go into Default

What if you can’t repay? You go into default, in legalese. It can happen when there isn’t enough money in your business bank account or your daily credit or debit card sales fall below what you contracted to pay. If that happens, multiple things can follow.

Even a single missed payment may give the MCA provider the right to call the advance. That means it can demand full payment of the entire contracted amount. Some contracts give the provider the legal right to take all deposits that come into your bank account to pay off the contract.

Many MCA providers require you to sign what’s called a “confession of judgment.” The clause means that you give up your right to defend yourself if the MCA provider accuses you of breaking the contract. That leaves the provider free to seize your assets.

Some MCA providers make you sign what’s called a “personal guarantee.” The personal guarantee can put your personal assets at risk if you don’t repay the contract.