Interest Rate vs. Factor Rate – The Difference

Today, there are a wide variety of funding options available to small and medium-sized businesses. From traditional bank loans and lines of credit to invoice financing and working capital loans, it’s easy to find and compare various loan options to meet your financial needs and budget.

One reliable way to choose the best small business financing is to compare the overall cost of the loan. To determine how much you’ll have to repay in total for your borrowed amount you need to look into the interest rate vs. factor rate.

Many small business owners are familiar with the term annual percentage rate (APR) or simply interest rates but certain types of business loans represent the cost of funding in the form of a factor rate. So if you’re planning to apply for a small business loan, it’s significant to know the difference between the two. In this blog post, we’ll explain what makes both different from each other and why every small business owner should care.

What Are Factor Rates?

The factor rate is expressed in a decimal form and not in the percentages the way interest rates are calculated. These rates usually range from 1.09 to 1.47. Similar to interest rates, this signifies how much you’re going to pay to obtain funding.

Factors rates are most commonly used in short-term business financing like a Merchant Cash Advance, where repayment terms are very short, typically daily or weekly. Factors rates are rarely used in the small business funding space, but they are not difficult to calculate.

What Are Interest Rates

The interest rate is one of the most common ways to signify the total amount (interest + principal) you would pay throughout the loan tenure. You’ve probably heard about this term since it’s how the most personal and business loans are priced.

This is expressed as an annual percentage rate (APR) and is used for credit cards, home mortgages, and traditional business loans such as an SBA loan, term loan, line of credit, or equipment financing.

How Factor Rates Are Calculated?

Calculating your factor rate is not as difficult as it seems, you get the total amount by simply multiplying your borrowed amount by the factor rate.

For Example:

Principal Amount – $10,000

Factor Rate – 1.25

Term – 18 months

Total Repayment – $12,500

Daily Payment – $265

Weekly Payment – $173

How Interest Rates Are Calculated?

The method of calculating the interest rate is somehow a little complicated. However, the most sought-after small business financing options involve charging fixed or variable interest on a set of percentages of the remaining principal at defined, regular intervals.

Here is the general formula to calculate interest on your loan amount:

Principal Loan Amount x Interest Rate x Time (aka Number of Years in Term) = Interest

For Example

Loan Amount – $500,000

Interest Rate (APR) – 7%

Loan Term – 10 Years

Total Repayment – $850,000

Monthly Payment – $7083

What Factors do Lenders Consider When Determining Your Factor and Interest Rate?

Factor Rate

Time in the business
Consistency of revenue
Seasonality of the business
Average monthly revenue

Interest Rate

Type of small business loan
Your business and personal credit score
Business type and industry
Payment history

Read Also: The Difference between Term Loans and Lines of Credit

Which One is Better For You Small Business?

The greatest factors in determining which rate is best for your small business are the type of business financing you need, creditworthiness, or how soon you need capital. Short-term business loans such as invoicing financing and Merchant Cash Advance with factor rates are great for entrepreneurs who don’t have ideal credit score and collateral to put up but need immediate cash to run and grow their businesses.

Factor rate financing may be beneficial for your business if you:

Need quick cash to manage day-to-day operations and other short-term business expenses
Want to make a steady and static payment
Recently launched a new venture but has a steady flow of revenue
Have low or no credit score
Don’t have collateral to secure funds
On the contrary, the interest rate can be a great option for small business owners who have a relatively better credit score or a little more time before they need working capital.

Interest loan financing may be a great fit for your business if you:

Prefer long repayment terms and lower EMIs
Have been in the business for more than 2 years
Want to choose and compare from a variety of loans
Have an ideal personal and business credit score
Have the ability to make payments on time
Show healthy business revenue

Bottom Line

No matter how you borrow money for your small business, it will always come with a cost. Loans with factor rates usually take shorter to get approved. The application process is typically more easy and fast and will require less documentation than financing like traditional bank loans.

Before choosing a loan type, it’s a smart idea to work with a financing professional you trust to help you choose the best loan options as per your current financial needs and budget. Besides, you can apply through an online lending marketplace to find and compare a variety of loan offers from multiple lenders to see if you should go for interest rate or factor rate.

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