What is a factor rate, and is 1.35 a good one?

A factor rate is the fixed multiple you pay back on a merchant cash advance or similar short-term financing. Multiply the advance by the factor and you have the total payback: $10,000 at 1.35 means $13,500 back, so the cost is $3,500. It is not an interest rate, and it says nothing about how long you have to pay, which is where the real cost hides.

How a factor rate works

The provider sets the factor when it makes the offer. It is applied once, to the whole amount, on day one. Unlike interest, it doesn't shrink as you pay down the balance. You owe the same $3,500 cost whether the money is repaid over 3 months or 12.

That's the catch. A cost of 35% sounds like 35% a year. It isn't. If you repay over 6 months, you only had the money for half a year, and you only had the full amount for the first day. Every payment reduces what you are using, while the cost stays fixed.

The worked number

Take the standard example: a $10,000 advance at a 1.35 factor, repaid daily over 6 months.

Scale it up and the APR stays put. A $50,000 advance at the same factor and term is $67,500 back, a $17,500 cost and 126 payments of $535.71, still about 126% a year.

The same 1.35 over 12 months works out to about 63%. Over 3 months it is about 250%. Same factor, very different price.

Why a factor rate is used at all

A cash advance is sold as a share of your future sales rather than as a loan, so the price is quoted as a multiple instead of interest. Disclosure rules are catching up. New York's commercial finance disclosure regulation requires providers of sales-based financing to show an estimated APR, with the line "APR is not an interest rate. The cost of this financing is based upon fees charged … rather than interest that accrues over time."

Sterling's take: the factor tells you the dollar cost. Only the APR tells you whether that cost is reasonable.

What changes the real cost

• Term. Shorter repayment means a higher yearly cost for the same factor.
• Fees taken off the top. If $500 of a $10,000 advance goes on fees, you receive $9,500 but still repay $13,500. The FTC has taken action against a provider it alleged hid fees that customers only saw after signing.
• Payment frequency. Daily payments return money to the provider faster than weekly ones, which nudges the APR up slightly.
• Early payoff terms. Some contracts discount the cost if you settle early. Most fixed-factor deals do not.

What to do next

1. Write down three numbers from the offer: the cash you will actually receive, the total payback and the number of payments.
2. Put them into the MCA APR calculator to see the yearly cost.
3. Read how to convert a factor rate to APR if you want to check the maths by hand.
4. Ask the provider in writing whether any fees come out of the advance and whether paying early reduces the payback.

If the APR comes out over 100%, that is very expensive money by Sterling's rule of thumb. It can still make sense for a short, specific gap with a clear payback, but you should know the number before you sign.