There are many different financing options that are available to business owners if they need working capital. Small business loans, business credit cards, private investors, venture capital, factoring or invoice financing, and crowdfunding are some of the ways business owners can gain access to the capital they need to run their business. A merchant cash advance is another financing option for business owners. Merchant cash advances are legal in all 50 states, but business owners should be cautious and do some research about this form of business financing before signing a contract.
How does a merchant cash advance work?
A merchant cash advance is not a loan, which means the business owner does not have to go into debt. Instead, the financing company will advance a certain amount of money upfront to the business owner in return for a percentage of future purchases that are made by credit or debit cards. In other words, the financing company is purchasing future credit and debit card sales. The financing company will collect a percentage of the daily sales where a credit or debit card is used to pay back the advance plus fees and interest until the advance is paid off. Merchant cash advances are set up through the business owners point-of-sale system.
Understanding the factor rate
When a business owner reads the terms of the merchant cash advance agreement, they will not see an interest rate or an APR. Instead, they will see a factor rate. The factor rate determines the total amount the business owner will have to pay back for receiving the cash advance. Factor rates are typically 1.1 to 1.5, and there is a lot that goes into determining what the factor rate will be for a business owner.
Business owners will understand how much they have to pay back by calculating the total amount of the cash advance times the factor rate. For example, let’s say a business owner is offered a $20,000 cash advance at a factor rate of 1.3 for a 12-month term. The business owner will have to pay back an additional $6,000 on top of the $20,000 advance. This translates to an interest rate of 51.44 percent. Unlike loans where payments on the interest get smaller as the principal is paid down, the factor rate is a fixed amount that is applied up front when the cash advance is originated. If a loan is paid off early, the borrower pays less in interest. No matter how fast a business owner pays off a merchant cash advance, they will still pay $26,000 in this example.
Is this considered usury?
Most states put maximum limits on how much interest lenders can charge borrowers, but these usury laws only apply to loans. Merchant cash advances are technically not considered loans because it is basically a purchase of receivables, so usury laws do not apply. Merchant cash advances are also not regulated under the Truth in Lending Act, which means merchant cash advances are largely unregulated. Currently, there is nothing that is stopping any financing company from setting a merchant cash advance factor rates above 1.5. These companies do a little bit of self-regulating, but this is only to avoid getting noticed by the state and federal governments.
Merchant cash advances are legal in all states and they do not violate usury laws, but state and federal regulators have taken notice of the high cost of these advances. Many business owners are also aware of the high cost of these advances. Business owners who are in need of working capital should consider other lower cost sources of capital like loans, business credit cards, crowdfunding, or invoice financing before considering a merchant cash advance.