Factor Rates vs Interest Rates: What They Mean

Key Takeaways on Factor Rates

• A factor rate is a simple calculation to indicate the total amount that a borrower will pay back on certain types of business financing. 

• To calculate payback, multiply the total borrowed by the factor rate (i.e., $10,000 borrowed x 1.5 factor rate = $15,000 total payback).

• Factor rates are used primarily in short-turnaround, higher-risk financing, like business cash advances.

What Is a Factor Rate?

A factor rate represents the total payback amount of specific types of business financing. Factor rates are expressed as a decimal number (ex: 1.5) and are typically used for business cash advances and other, similar business financing options. 

While both factor rates and interest rates help determine the cost of money borrowed, they’re not the same. 

• A factor rate is applied only to the original amount borrowed and acts as a flat fee for borrowing, which is then incorporated into the loan repayment schedule. 
• Interest rates “compound,” which means the amount of interest owed is calculated based on the remaining balance. The amount paid in interest varies somewhat through the life of the loan.

How Are Factor Rates Calculated?

When a business borrows, it owes the principal amount and whatever the lender charges to borrow that money. The factor rate is part of the formula that helps determine the total amount the borrower will pay back.

Borrowed Amount x Factor Rate = Total Payback Amount

For example, if a business takes out a $10,000 short-term small business loan (borrowed amount) with a factor rate of 1.3, the total repayment would be ($10,000 x 1.3) = $13,000 which means you’ll pay back a total of $13,000.

What’s the Difference Between Interest Rate and Factor Rate?

Interest rates and factor rates both relate to the amount a lender charges to borrow money. However, interest rates and factor rates differ as follows:

Factor Rates and Interest Rates are Expressed Differently

The most obvious difference between interest rates and factor rates is the way lenders display them. Factor rates are expressed as decimals (1.5) and interest rates as percentages (50%).

Factor Rates Don’t Change

One key difference between interest rates and factor rates for business loans is how—or if—they change. Factor rates are fixed and do not fluctuate during the life of the loan. Borrowers know up front exactly how much they’ll pay back, whether they pay early or on time.

Interest rates, however, can be either fixed or variable. When borrowing money with a variable interest rate such as a 10-year SBA loan, the variable interest rate will fluctuate as the prime interest rate changes. Additionally, total interest paid can be reduced through early payoff.

Compounding Interest Rates

Factor rates are static and based only on the amount borrowed.

Interest rates on business loans may be compounded daily or monthly or at other pre-disclosed intervals. Compounded interest is calculated by taking the percentage rate and dividing it by the number of times it “compounds.” For example, an annual interest rate of 10% that compounds daily would compound 365 times each year.

Compounded interest is calculated based on the total amount owed rather than the initial amount borrowed. So a $200,000 loan at 10% annual interest compounded daily would look like 

• Day 1: $200,000 owed
• Day 2: $200,000 + ($200,000 x .10/365) = $200,054 owed
• Day 3: $200,054 + ($200,054 x .10/365) = $200,108 owed

Remember, interest charges are based on the total amount owed. When a payment is made, total owed is reduced, which also reduces the amount of interest charged.

What Types of Business Financing Products Use Factor Rates?

Factor rates are often associated with less traditional, shorter-term, higher-risk financing, including the following:

Cash Advance (Business Cash Advance and Merchant Cash Advance)

Both business cash advances and merchant cash advances are common examples of financing products that use a factor rate. In both cases, lenders “advance” a business money based on future, anticipated income.

Business cash advances are tied to the overall financial performance of a business. Merchant cash advances are linked solely to credit card deposits. Both are paid back as a portion of daily sales, although a business cash advance’s specific repayment amount is calculated upfront and based on a “fixed daily percentage.” Payments can be structured as daily, weekly, or through other arrangements and are almost exclusively processed through an automated withdrawal of funds. 

Other Short-Term Business Loans

Other “short-term business loans” may use factor rates, if that’s how the lender structures the financing. Note, however, that financing will not use both a factor rate and an interest rate. 

Because the total payback amount can vary between factor rates, interest rates, and other repayment options, it’s important to fully understand the conditions of a short-term business loan before signing. Work with an expert, like a Lendio funding manager, to understand all of the terms, conditions, and payback amounts of each option presented.

Does Business Loans Charge an Interest Rate on Top of a Factor Rate?

Short answer: no. Business financing will not charge an interest rate on top of a factor rate. 

Note that the money you borrow with the help of a financing platform like Lendio, where a single application delivers your information to more than 75 different lenders, is required by law, in select states, to disclose all costs and fees upfront so you’re never wondering what you’ll pay.

If you have questions about financing offered through Lendio, please talk to your Account Executive, who can help you sort through the details, the overall cost to borrow, repayment schedules, and other information.

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_{Information provided on this blog is for educational purposes only, and is not intended to be business, legal, tax, or accounting advice. The views and opinions expressed in this blog are those of the authors and do not necessarily reflect the official policy or position of Lendio. While Lendio strives to keep its content up-to-date, it is only accurate as of the date posted. Offers or trends may expire, or may no longer be relevant.}