What is a Factor Rate and How to Calculate It

If you take out a short-term loan, a bad-credit loan or a merchant cash advance, you might be charged a factor rate instead of an interest rate. 

Factor rates are decimals that the lender uses to calculate the total cost of the loan. While it’s simpler to use a factor rate to find out how much you’ll be paying, factor rates tend to be much higher than interest rates – sometimes costing as much as 50 percent of the loan balance, not including fees. 

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 loans such as:

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 2 and only apply to the original amount of money borrowed. This is unlike compound interest, which is calculated using both the original balance of the loan and whatever interest has accumulated on the loan. 

Factor rates are fixed cost, meaning that your payment amounts will remain the same from week to week or month to month. 

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.

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 fees 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.

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 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 by subtracting the original amount borrowed from the overall loan amount. Example: $150,000 – $100,000 = $50,000

Step 3: 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 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 much a loan costs with a factor rate

The higher your factor rate, the more you’re going to be paying on the loan. While factor rates don’t have compound interest, they do tend to be higher than interest as a whole, and often have a more aggressive repayment schedule with possible weekly payments. 

To illustrate the cost of a factor rate, here’s what you’ll pay for a 12-month loan based on different factor rates.

This is the key downside of business loans for bad credit – they tend to come with higher factor rates, and thus 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

• Why do lenders use a factor rate instead of an interest rate
  

  Factor rates can present loan costs in a more straightforward way than APR, which requires an amortization schedule to calculate compound interest and the monthly or weekly payment. That can make for a faster lending process, especially for speedy loans like merchant cash advances or short-term loans with weekly payments.

   

• How do lenders determine the factor rate?
  

  Lenders will look at your credit history, business revenue, debt-to-income ratio and your industry to determine what factor rate they’ll offer you. In general, the higher your revenue and credit score, and the lower your debt-to-income ratio, the better factor rate you’ll be offered.

• Should I take out a loan with a factor rate?
  

  It depends on what you’re looking for in a loan. Factor rate loans tend to be faster and catered to businesses with lower credit score or with less time in business. They do come with higher fees when compared to more traditional, APR-based loans, and have more aggressive repayment periods.