If you’re looking for cash to fund business growth, odds are you’ll do it with a bank loan or a line of credit. But, especially for smaller businesses, merchant cash advances are another popular source of funds.
Either a loan or a cash advance may be a good choice, depending on how the proceeds of the loan will be used.
“Loan purpose should drive the whole conversation,” said Ty Kiisel, head of financial education for OnDeck, an online provider of business loans. “That is going to tell you how much money you need and how much you can afford to spend for it.”
The mechanics of merchant cash advances
Although both financing methods involve receiving and repaying a sum of money, merchant cash advances are not the same as loans. Rather, the business receives an advance against its future credit card sales, and the provider draws money from the business’s future credit card transactions as repayment. Payments are made daily or sometimes weekly.
The repayment amount is based on a percentage of daily credit card sales called the holdback, which may range from 5 percent to 20 percent. For example, if a business does $10,000 in credit card sales, and the holdback is 10 percent, the repayment amount would be $1,000. The holdback percentage doesn’t change. However, the payment amount may vary depending on the volume of credit card transactions.
The cost of an advance, called the factor rate, is also a preset figure. Also called the buy rate, it is usually expressed as a figure such as 1.2 or 1.4. An advance with a factor rate of 1.3 means the business will repay $13,000 for every $10,000 advance for a period of a year.
The way merchant cash advances are priced can make it difficult to compare their cost with business loans. An advance charges all interest on the full amount upfront, while a loan charges interest on a smaller amount each month as the principal is paid off. So a $30,000 charge for a $10,000 advance is not equal to a 30 percent annual percentage rate (APR) business loan. Instead, it is closer to a 50 percent APR. With additional fees, the effective rate can go much higher.
Users of advances often don’t realize the true cost, In few cases customers who have taken out merchant cash advances and are paying an APR north of 150 percent and not even knowing it.
Advances are short-term financing, and so are best suited for short-term for needs such as acquiring inventory. Most are designed to be repaid in six to 24 months. And unlike most loans, paying off a merchant cash advance early will not produce any savings. The factor rate is the same whether it takes the full intended term to pay back the advance or a shorter or longer time.
Because an advance does not require set monthly payments, a business will pay more when sales are good and less when sales are down. This can help to avoid cash crunches that might be more frequent with set monthly payments.
For a business that is seasonal, that can be a lifesaver, If they have a down month, they’re not going to have to cover the fixed cost of a small business loan.
Overall, a business loan can be significantly less costly than a merchant cash advance. Hecht advised always checking to see if a business loan is available before taking an advance. For instance, he says some merchant cash advance users could quality for SBA-backed loans carrying a rate of 7 percent.
A merchant cash advance can be tempting, but there are numerous pitfalls that can leave small business owners in poor financial shape.