A factor rate is a number that lenders use to determine the total amount a borrower will pay back on a loan, regardless of how quickly they repay it, by multiplying the amount borrowed by the factor. Here’s the formula:
- Repayment Amount = Amount Borrowed x Factor Rate
When you borrow $100,000 at a factor rate of 1.25, you’ll pay a total of $125,000.
Factor rates are great if you’re taking emergency loans, payroll loans, or working capital loans where you need cash now and want flexibility. Factor rate financing is different from traditional small business loans, which are based on interest rates and equal monthly payments across the loan term.
Let’s walk through an example of how factor rates work to make it easy to compare loans across lenders since you know the total amount you’ll need to repay by a certain time. Then you’ll learn how to compare them against interest rate loans and also an additional type of funding that uses a discounted factor rate.
Repayment and Loan Comparison
The factor rate tells you how much you need to repay by a certain time so you can compare offers from lenders and choose the best one for your estimated future cash flow. For example, you need to borrow $50,000 and lender 1 gives you a factor rate of 1.1 for 6 months, while lender 2 gives you a factor rate of 1.2 for 10 months:
| Lender 1 | Lender 2 | |
| Amount borrowed | $50,000 | $50,000 |
| Factor rate | 1.1 | 1.2 |
| Repayment amount | $55,000 | $60,000 |
| Term | 6 months | 10 months |
You quickly see that you need to repay $5,000 more for lender 2, so the overall cost of the loan is more expensive. But you have an extra 4 months to repay. If you’re buying additional inventory with a working capital loan because product is flying off the shelves, lender 1 will be a better option since your cash flows will come quickly to repay the loan. But if you need the money to fix hurricane damage and you’re not sure how quickly customers will return, then lender 2 would be a better option for the longer timeline to repay.
Comparing Factor Rate to Interest Rate Loans
To compare factor rate loans to interest rate loans, follow this 3-step process:
- Convert the interest rate loan to the total amount repaid.
- Convert factor rate to total repaid.
- Compare loans and account for additional terms with the interest rate loan.
Step 1 is to figure out the total amount you’ll repay on the interest rate loan, including all the interest and fees like origination fees, application fees, processing fees, and others, using this formula:
- Total Repayment (Interest Rate Loan) = Loan Amount x (R/12 x (1 + R/12)^M) / ((1 + R/12)^M – 1) x M + Fees
- R is the annual interest rate
- M is the number of monthly payments
- A $100,000 loan at 30% for 6 months and $2,000 of fees would be = $110,897.60
Step 2 is to calculate the factor rate loan repayment using the formula:
- Repayment Amount = Amount Borrowed x Factor Rate
- A $100,000 loan with a 1.15 factor rate for 6 months would be $100,000 x 1.15 = $115,000.
Step 3 is to compare loans taking into account other terms with interest rate loans. You’ll pay an additional $4,102.40 over 6 months for the factor loan, but that could be worth it if you aren’t certain of your cash flow because of other terms that come with interest rate loans, including the following:
- Late fees will cost you extra if you miss a payment or you’re a day late. With factor loans, you only have to worry about paying the total amount by the end of the loan.
- Adjusting rates can trigger higher rates for the rest of the loan if you miss payments, making it more expensive overall.
- Default penalties can occur on some interest rate loans if you miss a payment or you’re late by a certain number of days. Defaults will likely hit your business credit report if the loan is tracked, hurting your score and making future loans both harder to get and more expensive.
Compare your forecasted sales over the life of the loans so that you have confidence in cash flow when compared to loan payments. This will help you choose which loan is better for the business.
Additional Factor Rate Usage
While most factor-rate-based loans tell you how much you’ll have to pay back in total for a loan, factor rates are also used in financing like invoice factoring, where you sell the invoices to a lender for a discount based on the factor:
- Amount You Receive = Value of Invoices x Discount Factor Rate
This is different from a loan because you’re selling the invoices to the lender and instead of collecting from you, they collect from customers. This type of factor-based financing is great for two reasons:
- You get immediate cash and don’t have to wait for or bother customers for payment.
- The factor rate is based on your customer’s credit instead of yours making this a great way to get funding if you’re worried about a ding to your credit score or if you’re a new business without a score.
Factor rates make it quick and simple to know exactly how much you need to repay within a time period so you can choose the right loan for your situation without guesswork. You’ll have certainty over the total amount and have flexibility within that time period to repay as cash flows fluctuate.
