What is a factor rate and how to calculate it

Key takeaways

• Factor rates are a fixed fee multiplied by the entire loan up front, which means that you’ll pay the entire fee even if you pay the loan off early

• To compare loans with traditional interest rates and factor rates, you’ll need to convert factor rates to interest rates

• Factor rate loans can come with interest rates of 50 percent or more, so understand the full cost before signing the loan agreement

When you take out a business loan, your lender may use factor rates instead of interest rates to determine how much you’ll pay for the loan. Many alternative forms of funding use factor rates, including short-term loans and merchant cash advances.

Factor rates are decimals that the lender uses to calculate the total cost of the loan. This method can look simple from the outside, but when converted to an interest rate, the true loan cost can easily translate into a 50 percent APR or more. But unlike an APR, factor rates don’t include additional loan fees, making it even more difficult to compare with other loans.

Before signing on the dotted lines for a factor rate loan, you’ll want to understand how factor rates are calculated and how to convert them to an interest rate to make sure you’re getting a fair loan offer.

What is a factor rate?

A factor rate is a method of identifying how much a loan will cost you. It is expressed as a decimal that gets multiplied by the principal loan amount. It’s used in place of the interest rate and is often found with high-risk loans available to business owners with bad credit.

You might see factor rates used with these types of loans:

• Merchant cash advances: advances against your business’s future credit and debit card sales

• Business lines of credit: lines of revolving funds that you can use as needed and borrow from again as you repay previous loans

• Short-term loans: A loan with a set repayment term, typically 24 months or less for a short-term loan

How do factor rates work?

Factor rates work by multiplying the decimal by the entire loan amount upfront. Factor rates typically range from 1.10 to 1.50 and only apply to the original amount of money borrowed. It’s a fixed cost that doesn’t change throughout the life of the loan, unlike a variable interest rate loan, which can change.

However, the fixed cost means that you may be responsible for the entire factor rate fee even if you repay the loan early. To save money, you can look for a factor rate loan with a prepayment discount.

Factor rate vs. interest rate

By comparison, most business loans calculate the interest rate with each payment, typically monthly. The interest rate is expressed as a percentage, which is multiplied by the current balance of the loan.

As your balance decreases, the amount of interest you pay decreases as well. Since the interest is calculated with each payment, if you pay back the loan early, you typically save money on interest.

In many cases, the percentage shown for the business loan is the annual percentage rate (APR). The APR is the total loan cost of the loan over one year, and it’s made up of the interest rate plus additional loan fees like origination or underwriting fees. This can give you a complete idea of the total amount you will repay over the course of a loan.

Bankrate insight

Some lenders charge a prepayment penalty, which is a fee that can help lenders make up for the loss of interest income they lose when borrowers pay back loans early. Check how the lender handles prepayment if you plan to pay off your loan early.

How to calculate a factor rate

Using the factor rate provided by the lender, you can quickly calculate the cost of the borrowed funds.

For example, if you borrowed $100,000 with a factor rate of 1.5, multiply those two figures together — $100,000 x 1.5. This gives you $150,000, the total amount you’ll need to repay.

If you want to know the total fee you’ll be charged, you would subtract the amount borrowed from the total loan cost: $150,000 (total loan cost) —$100,000 (original loan amount) = $50,000 (total fee charged). The $50,000 is the cost of borrowing the original $100,000.

Bankrate insight

Loans with factor rates tend to have short repayment periods of 24 months or less. If it took you two years to pay off a $100,000 loan with $50,000 in interest, you’d pay the equivalent of more than 42 percent interest per year.

How to convert a factor rate to interest rate

It’s difficult to compare loan products when one is quoted with a factor rate and the other as an interest rate or APR. To better understand what you’d actually pay, you can convert the factor rate to interest rates to see how much you’ll pay in interest each year (annualized interest rate) you hold on to the loan.

While this doesn’t consider any fees you may be charged, it can give you a better point of comparison between the two loan products.

Here are two methods for converting a factor rate to interest rates.

Method one

Step 1: Subtract 1 from the factor rate

Step 2: Multiply the decimal by 365

Step 3: Divide the result by your repayment period

Step 4: Multiply the result by 100

Here’s an example using the $100,000 loan with a factor rate of 1.5 and a two-year (730 days) repayment period:

Step 1: 1.50 – 1 = 0.50

Step 2: .50 x 365 = 182.50

Step 3: 182.5 / 730 = 0.25

Step 4: 0.25 x 100 = 25%

If you want to convert factor rates to annual interest rates using your loan amount, try method two.

Method two

Step 1: Find your overall loan amount

Find the overall loan amount by multiplying the amount to be borrowed by the factor rate

Example: $100,000 x 1.5 = $150,000

Step 2: Find the total interest costs

Find the total interest costs by subtracting the original amount borrowed from the overall loan amount.

Example: $150,000 – $100,000 = $50,000

Step 3: Convert interest cost to a percentage

Convert the total interest cost to a percentage by dividing the total interest costs by the original amount borrowed.

Example: $50,000 / $100,000 = 0.5 (50%)

Step 4: Find the annual interest rate

Find the annual interest rate by multiplying the percentage by the total number of days in a year.

Example: 0.5 x 365 = 182.5

Then, divide that figure by the number of days in the repayment period.

Example: 182.5 / 730 = 0.25 or 25%

Just like with method one, this gives you an annual interest rate of 25 percent. Keep in mind these calculations do not include any additional fees charged on the factor rate loan, so the APR may be higher.

How lenders determine your factor rate

Factor rates are commonly applied to business loans for bad credit borrowers, which means you can expect fees to be higher than a conventional business loan. You may qualify for a lower factor rate if your business proves to be low risk to the lender. Lenders may consider these factors when determining  your creditworthiness:

• Credit history: If you have fair or good credit or a history of making regular, on-time payments, the lender may consider you a lower risk.

• Cash flow: You may need to show a healthy amount of revenue and positive cash flow through your business.

• Debt-to-income ratio: The lender may take stock of how much debt you have and how much debt you can take on based on your business’s revenue. Low revenue may put you in a higher risk category than businesses with high revenue.

• Industry risk: If businesses in your industry have a high success rate, that may influence how the lender perceives your business for its loan decision.

The true cost of your loan

Once you’ve converted your factor rate to an interest rate, use a business loan calculator to see how much the same loan would cost with an APR. For the $100,000 loan, the total fee charged with a factor rate is $50,000.

Here’s the total interest and loan cost if you received the same loan with an APR:

For example, a $100,000 business loan paid off in two years with a 25 percent interest rate would cost $28,091.65 in total interest. That amount is far less than the $50,000 in interest you’d pay with the same loan and a factor rate of 1.50.

Most factor rate loans offer accessible loan requirements for borrowers who typically get edged out of conventional business financing. The downside is that business loans for bad credit tend to come at a higher cost.

Bottom line

Factor rates are used instead of interest rates by some lending institutions to determine the total costs of certain types of loans, including merchant cash advances and some business lines of credit. Before signing on for this type of financing, it’s important to know exactly how much you’ll be charged and how the factor rate compares to interest rates. This will help you compare various loan products and make the best decision for your business.

Frequently asked questions

• What is a 1.5 factor rate?A factor rate of 1.50 is on the high end of what a lender may charge to borrow money. You can determine the cost of the money you want to borrow by multiplying the amount you want to borrow by a factor rate of 1.5. For example, it will cost you $25,000 to borrow $50,000 at a 1.50 factor rate ($50,000 x 1.5 = $75,000).

• What is a 1.35 factor rate?A 1.35 factor rate is a mid-range rate lenders charge to borrow money. Factor rates typically fall between 1.1 and 1.5. With a 1.35 factor rate, it will cost $35,000 to borrow $100,000 ($100,000 x 1.35 = $135,000).