If you’ve applied for financing and had a financing company quote their pricing as a “Factor Rate” or “Buy Rate” rather than an interest rate, you’re probably scratching your head.
Why do some financing companies quote their pricing this way?
It all comes down to the fact that their products don’t look like traditional bank loans.
Traditional banks loans are amortizing. With an amortizing loan, your payment is the same each month. With each payment, you’ll pay down your interest on that month’s unpaid principal and you’ll pay down your total principal outstanding.
In month 1, you’ll pay $170 to principal and $80 to interest.
In month 2, you’ll pay $180 to principal and $70 to interest.
And in month 3, you’ll pay $190 to principal and $60 to interest.
But with some other types of financing like short-term loans or merchant cash advances, the financing is structured in a different way. Instead of charging interest on the principal remaining at the time of each payment, lenders charge all your interest up front. So for every payment, you’re paying the same amount to interest and the same amount to principal, no matter if you pay it back early.
So these financing companies use what is called a factor rate (like 1.2) rather than an interest rate (like 10%) to quote how much their financing will cost you.
What exactly is a factor rate?
A factor rate is simply a multiplier that tells you the total amount you’ll pay back.
Here’s how it works!
Let’s say you borrow 10,000 at a factor rate of 1.2.
All you do is multiply the two numbers together to get the total amount you’ll pay back. So for this advanced amount, you’ll pay back ($12,000). An important thing to note is that with financing quoted with factor rates, you’ll often owe the full amount ($12,000 in this case) regardless of whether you decide to pay back early or not.
At first glance, when you convert a factor rate to APR, the APR might seem especially high. But your total cost of capital (or the amount you’re charged for borrowing the money) won’t be. So you’ll need to ask yourself: Do you want lower individual payments? Or do you really just care about what the financing is costing you?
Let’s look at an example.
Sarah is the owner of Sarah’s Bakery. She’s looking to get a loan to help improve her cash flow for a few months. Sarah is offered 2 loans: the 1.2 factor rate, 74.81% APR, 6-month loan we talked about earlier and a 10% APR 5-year loan.
10 % APR
$212.47 — Monthly
$2.748.23 — Total Payback
74.81 % APR
$90.91 — daily payment
$2,000.00 — Total Payback
While loan 1 has lower payments and lower APR, loan 2 has a lower total payback.
Sarah can decide if she’d rather have a lower total payback or if she wants lower payment.
In short, always multiply the factor rate by your loan amount to see how much you’ll pay back. If you want to compare it to other loans and calculate the APR. You’ll likely find the APR to be high, but remember to also compare the total cost of capitals.
You can play around with factor rates and APRs on our resources page or check out our video on APR vs. Cost of Capital video here.
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from Fundera Ledger https://www.fundera.com/blog/fundera-whiteboard-series-factor-rate