The merchant cash advance is one of the easiest to get but often the most expensive type of business debt. The idea seems appealing: sell a portion of your future daily credit card receipts from sales, and in return receive a lump sum payment now. If you have steady credit card receipts from customer purchases – for at least 2 years, and running now at least $50,000/year – you can qualify even if your credit rating is not so good.
Part of the appeal is that repayments are not fixed: they go down when sales go down, and come back up when sales are up. However, sometimes businesses don’t fully appreciate the impact of daily repayment on cash flow. It doesn’t stop until the advance is paid back.
Merchant cash advance terms
While technically not a loan, a merchant cash advance feels like one. The terms are a bit different from a loan so it’s sometimes hard to compare them to more conventional debt.
You get charged a “factor rate,” which is essentially a fixed fee plus the amount you got as an advance, ranging from 1.1 to 1.4 times what you borrow. To figure out the costs, you multiple that times the advance. For example:
- a $20,000 merchant cash advance with a factor rate of 1.2 means you have to pay back 1.2 times $20,000, or $24,000. The fee, then, is $4,000.
To translate this into the equivalent of an interest rate, you have to figure out how fast it’s going to be paid back. Merchant cash advances start taking daily withdrawals from credit card receipts ranging from 8% to 30%. So keeping with the above example, let’s assume a 15% daily holdback on a business that is generating an average of $1,000 per day in credit card sales, or $365,000 per year. Here’s the math on payback period:
- 15% time $1,000 per day = $150 per day paid back.
- It will take 160 days to pay back $24,000 ($24,000 divided by $150 equals 160)
Finally, dividing 365 days in a year by 160 gives you 2.28, which you would use to figure out roughly how much this would cost if you did it all year:
- 2.28 X $4,000 = $9,125 = 45% of $20,000
In other words, in this case the merchant cash advance is the equivalent of getting a loan at a 45% interest rate. Like we said, this is very expensive. But it could be even worse!
The two terms both affect how high the comparable interest rate would be. If the factor rate is higher – 1.4 instead of 1.2 – the interest rate would go up. If the holdback rate is higher, that means the advance is paid back sooner so the comparable interest rate would be higher. Finally, if the amount of daily credit card receipts is higher, that also makes for a faster payback which drives up the comparable interest rate. Here are some “even worse” scenarios of our example:
- $20,000 advance, factor rate of 1.4 with 15% holdback on $1,000/day of sales yields a 78% interest rate
- $20,000 advance, factor rate of 1.2 with 25% holdback on $1,000/day of sales yields a 76% interest rate
- $20,000 advance, factor rate of 1.4 with 25% holdback on $1,000/day of sales yields a 130% interest rate
- $20,000 advance, factor rate of 1.4 with 25% holdback on $1,500/day of sales yields a 194% interest rate. Yikes!
Now, we don’t think this worst case scenario would happen – most of the time. But we hope this shows you need to pay close attention to the terms, and do your math!
Or, look hard for another shade of debt.