What is a factor rate and how to calculate it
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When you take out a business loan, your lender may use interest rates or factor rates to determine how much you’ll pay for the loan. If you’ve bought a house, a car or used credit cards, you’re familiar with the use of interest rates.
Factor rates, on the other hand, are often used for alternative forms of funding, such as short-term loans and merchant cash advances. Factor rates offer a simple method to calculate the cost of a loan but can hide just how expensive that loan may be.
Understanding how a factor rate works is important if you want to understand the true cost of your loan. Here’s everything you need to know about factor rates, including what they are and how to calculate them.
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 and is often found with alternative loans, especially short-term, high-risk loans available to business owners with bad credit. This includes:
- Merchant cash advances: advances against your business’s future credit and debit card sales
- Business lines of credit: lines of revolving funds available on an as-needed basis
- Invoice factoring: an advance on outstanding invoices.
Factor rates typically range from 1.1 to 1.5 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 or business line of credit.
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. This is the total amount you’ll need to repay.
The $50,000 is the cost of borrowing the original $100,000. And the full $50,000 must be paid unless the lender offers prepayment discounts and you can pay off the full loan in time to earn the discount.
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% interest per year.
Factor rate vs. interest rates
Interest rates are expressed as percentages that determine the cost of borrowing money. Once your interest rate is set, you’re charged monthly interest until the balance is paid off. As your balance decreases, the amount of interest you pay is also reduced.
While factor rates are fixed and only apply to the original amount borrowed, interest rates can be either fixed or variable (the rate charged could change over the loan term) and apply to the remaining balance. This amount compounds throughout the repayment period, meaning you’re paying interest on the remaining balance and unpaid interest.
When an interest rate is used, it’s possible to pay less interest than the original stated amount. For example, if the loan’s original term is five years, but you pay it off in four years, you’ll pay less interest than you were quoted based on the five-year payment term. This is because you have removed 12 months of the interest being compounded.
Some lenders charge a prepayment penalty, which is a fee that can help lenders make up the loss of interest income they lose when borrowers pay back loans early.
The annual percentage rate (APR) is the total loan cost for one year. It’s made up of the interest rate plus additional loan fees. This can give you a complete idea of the total amount you will repay over the course of a loan.
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.
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.
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 by 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%. Keep in mind, these calculations do not include any additional fees charged on the factor rate loan, so the APR may be higher.
|Step 1: Find the overall loan amount||$100,000 x 1.5 = $150,000|
|Step 2: Find the total interest costs||$150,000 – $100,000 = $50,000|
|Step 3: Convert cost to a percentage||$50,000 / $100,000 = 0.5 (50%)|
|Step 4: Find the annual interest rate||0.5 x 365 = 182.5|
|Step 4 (continued):||182.5 / 730 = 0.25|
|Estimated annual interest rate||25%|
The true cost of your loan
Once you’ve converted your factor rate to an interest rate, you’re not done yet. Grab a business loan calculator and see how much your loan would cost if you pay the interest rate you just calculated.
For example, a $100,000 loan paid off in two years with a 25 percent interest rate would cost $28,091.65 in total interest — far less than the $50,000 in interest you’d pay with the same loan and a factor rate of 1.5.
Most loans with factor rates provide fast and easy access to funds for business owners who typically may not get approved for traditional loans with APRs. The downside is that those loans come at a sizable cost.
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
A lender may provide you with a factor rate for the financing you’re seeking. This is typically a figure between 1.1 and 1.5. Multiply the loan amount by that factor rate to find the total cost of the loan. For example, if you’re borrowing $100,000 at a 1.5 factor rate, the cost to borrow that money is $50,000 ($100,000 x 1.5 = $50,000).
A factor rate of 1.5 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 1.5 factor rate ($50,000 x 1.5 = $75,000).
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).