Definition and Examples of Factor Rates
How Factor Rates Work
How to Calculate Factor Rates
Are Factor Rates Higher than Interest Rates?
Definition and Examples of Factor Rates
The factor rate is used to calculate the cost for a borrower to obtain a loan, including the principal amount and total interest, and is expressed as a decimal fraction. When you borrow a business loan, you repay the borrowed amount plus interest. In some cases, the interest rate is expressed as a percentage (10%), and in other cases, it is expressed as a decimal fraction (1.1). When the rate is expressed as a decimal fraction, it is referred to as the factor rate.
For example, Joe Smith’s Manufacturing Company obtains pre-funding with a factor rate of 1.2. This means that if Joe’s Company borrows $1,000, they will repay $1,200. Factor rates typically range between 1.1 and 1.5, indicating how much you will repay on the borrowed amount in your business loan. However, the factor rate you qualify for will depend on criteria such as the length of time in business, your industry, your revenue, and your financial outlook.
Although factor rates are somewhat comparable to interest rates, or Annual Percentage Rate (APR), there is a key difference. While factor rates apply only to the original borrowed amount – not accumulating or changing over time as you repay the loan – the annual percentage rate (APR) changes over time as the principal loan amount decreases.
How Factor Rates Work
Although factor rates are specifically used for business financing (not personal loans), they are not typically applied to traditional business loans. In fact, unless you are applying for pre-funding for merchant cash or another form of small business financing, such as a short-term loan, you may never see this term.
Will your factor rate be high or low?
Factor rates will vary depending on your answers to several key questions, including:
- What is your industry? If you operate in a seasonal business, you may have to deal with a higher factor rate. The same is true if you operate in a high-risk business or in an industry that is declining (such as travel agencies).
- How long have you been in business? The longer you have been in business, and the stronger your track record, the more likely your factor rate will be lower.
- Is your company stable and growing? If your company is stable and growing, you are a good credit risk. If not, you may pay for your instability with higher factor rates.
Note: If you are applying for pre-funding for merchant cash, your factor rate will also heavily depend on your monthly credit card sales. This is because merchant cash funding is repaid through monthly credit card income.
How to Calculate Factor Rates
It is a relatively simple process to calculate factor rates. You just multiply the principal amount you are borrowing by your factor rate. For example, if you are borrowing $1,000 at a rate of 1.3, multiply 1000 × 1.3, and you will find that you will pay $1,300 for your loan.
Are Factor Rates Higher than Interest Rates?
Loans using factor rates can sometimes be, but not always, higher than those carrying interest rates or interest rates. This is because even if the rate seems higher initially, the latter type of loans:
- Changes over time for many different reasons. For example, the actual annual percentage rate (APR) may increase if you miss a payment. And even if you do not miss a payment, the annual percentage rate (APR) may increase if the base interest rate goes up.
- Often
You cannot repay the loan early as a condition. This means that you have less flexibility in using your money. - It may be out of your reach if your company has a bad credit history. The application process can take a long time as lenders decide whether you qualify or not.
Key Factors Considered
- Factor rates help describe the amount you pay for a business loan and are expressed as a decimal fraction.
- Factor rates are typically applied to merchant cash advances or other short-term unconventional business loans.
- Your factor rate is applied to the entire loan and will not change throughout the life of the loan.
- The factor rate you receive is determined based on your company’s financial stability, credit rating, industry, revenues, and other issues.
- Loans using factor rates are usually available even if you have a bad credit history and can provide funding quickly.
Source: https://www.thebalancemoney.com/what-is-a-factor-rate-5221497
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