If you’ve taken out a short-term business loan or applied for revenue-based financing lately, there’s a good chance you’ve come across the term “factor rate” in some capacity.
While similar to an interest rate, there are a few differences that make it unique. These differences are important to understand as you apply for financing.
Continue reading for everything you need to know about factor rates in financing, including what they are, how they work, and how they are different from interest rates and other structures.
What Is a Factor Rate?
A factor rate (or money factor) is a way of expressing the amount of interest that a bank or alternative lender charges on a loan.
Confusion can sometimes arise when comparing factor rates to interest rates or to an annual percentage rate (APR).
Find the answer to this question below, as well as everything else you need to know when considering how factor rates can affect how you finance your business.
How Does a Factor Rate Work?
The good news here is that a factor rate operates more simply than an interest rate.
A factor rate is a percentage (often expressed as a decimal ranging from 1.1 to 1.9) that shows how much “extra” you owe on a loan.
For example, if you’ve taken out a short-term loan for $1,000 and your factor rate is 1.21, multiply the two numbers together to arrive at the “true” amount of money you’ll have to pay back on the loan. (In this instance, it’s $1,210).
Interest Rate vs. Factor Rate vs. APR
| Type of Rate | Description |
| Interest Rate | The interest rate is a fixed or variable percentage that’s applied to every payment. The amount is compounded, meaning the interest payment depends on the borrower’s principal amount at the time of their payment.
For example, someone’s first interest payment of a $100,000 loan with a 12% interest rate would be $12,000. Once they’ve reduced the principal to $50,000, their interest payment will be $6,000 for that payment. |
| Factor Rate | A factor rate is a number, usually ranging from 1 to 1.7, that’s multiplied by your total loan amount to determine your cost of capital. Unlike interest rates, factor rates apply to the entire principal amount, which gives borrowers a better understanding of their total cost of capital from day one. |
| APR | The annual percentage rate (APR) is a more comprehensive tool used to showcase the total cost of borrowing. Your APR includes interest, fees, and any other costs associated with your loan. |
Unlike interest rates, which can compound as you pay off your loan and change as your debt decreases, factor rates apply only to the original loan number.
So, considering our example before, if you borrow $1,000 and the factor rate is 1.21, the factor rate will remain 1.21 until the debt is paid off completely. Always be aware that factor rates don’t change like interest rates, and so they need to be calculated differently when assessing your APR.
Note that APR is an expression of the total you owe on a given loan, including other fees and payments not relating to your factor rate. However, you can use your money factor to determine your APR, should you be so inclined.
How to Calculate Factor Rate
Your factor rate is provided when you’re approved for financing. This number can be negotiated, but once it’s set in place, it stays as a stagnant number for the duration of your repayment.
The factor rate is used to determine a borrower’s cost of borrowing. Once you have your factor rate and funding amount, you can multiply the two numbers together and see your cost of capital.
Factor Rate x Principal = Cost of Borrowing
Much like interest rates, lenders use a variety of factors to determine a factor rate. A business’s financial background, industry, business plan, and future outlook are all considered, among many other factors.
How Are Factor Rates Used?
Factor rates are used by lenders to impose a cost of borrowing on businesses. It’s their way of earning a profit by offering a service, but it’s also used to protect lenders from the financial loss associated with a defaulted borrower.
Risk and market conditions determine a borrower’s factor rate. If the borrower poses more of a risk of default, whether through a troubled credit history or another factor, they’ll receive a higher factor rate than a safer borrower because the lender wants to protect themselves.
In many ways, factor rates are more straightforward than interest rates because the amount paid stays stagnant throughout the repayment. There’s no compounding effect, so the amount you’re paying at the beginning of your term is the same amount you’ll pay at the end of your term.
So What Do Factor Rates Mean to My Business?
Now that you’ve got a stronger grasp of what factor rates are, you might be wondering what they mean to your business. As stated before, factor rates often appear when you apply for a short-term loan or revenue-based financing, otherwise known as a cash advance.
And it’s important to remember that when you consider your financial options. You should also recognize that the amount of the loan, your business’s credit history, how long you’ve been conducting business, and many other aspects of your situation can affect the factor rate on your loan. And obviously, the lower the factor rate, the better it is for you!
Next Steps
Looking to get cash quickly to seize an opportunity for your company? Contact National Business Capital’s team today! We can answer your questions and put your mind at ease with the funds you need to get the most out of your business.
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Joseph Camberato
Joe Camberato is the CEO and Founder of National Business Capital. Beginning in 2007 out of a spare bedroom, Joe and his team have financed $2+ billion through more than 27,000 transactions for businesses nationwide. He’s made it his calling to deliver the educational and financial resources businesses need to thrive.
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