If you’re looking for cash to fund your business growth, chances are you’ll do it with a bank loan or line of credit. But, especially for small businesses, merchant cash advances are another popular source of funds.
A 2015 Federal Reserve Bank of New York study found that while loans and lines of credit were the most popular method of financing among small businesses (57% and 52%, respectively), 7% had used merchant cash advances during the year former. Small businesses were more likely to do so: 10% of micro businesses (turnover less than $100,000) made cash advances to merchants last year.
A loan or cash advance may be a good choice, depending on how the loan proceeds will be used.
“The purpose of the loan should drive the whole conversation,” said Ty Kiisel, head of financial education for On the bridge, an online business loan provider. “It will tell you how much money you need and how much you can afford to spend on it.”
The Mechanism of Merchant Cash Advances
Although both methods of funding involve receiving and repaying a sum of money, merchant cash advances are not the same as loans. Instead, the company receives an advance on its future credit card sales, and the vendor takes money from the company’s future credit card transactions as reimbursement. Payments are made daily or sometimes weekly.
The refund amount is based on a percentage of daily credit card sales called a holdback, which can range from 5-20%. For example, if a business has $10,000 in credit card sales and the hold is 10%, the refund amount would be $1,000. The retention percentage does not 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 predefined figure. Also called buy rate, it is usually expressed as a number 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 over a one-year period.
The way merchant cash advances are priced can make it difficult to compare their cost with business loans. An advance charges full interest on the full amount up front, while a loan charges interest on a lower amount each month as the principal is repaid. Thus, a $30,000 fee for a $10,000 advance does not equal a 30% business loan at the annual percentage rate (APR). Instead, it’s closer to a 50% APR. With additional fees, the effective rate can go much higher.
Jared Hecht, co-founder and CEO of the New York-based company Funderaan online platform to connect businesses with loans and advances, says advance users often don’t realize the true cost.
“We’ve seen clients who have taken merchant cash advances and pay an APR north of 150% without even knowing it,” Hecht said.
Advances are short-term financing and are therefore best suited in the short term for needs such as the acquisition of inventory. Most are designed to be paid off in six to 24 months. And unlike most loans, prepaying a Merchant Cash Advance won’t produce any savings. The factor rate is the same whether it takes the full term to repay the advance or a shorter or longer term.
Since an advance does not require fixed monthly payments, a business will pay more when sales are good and less when sales are down. This can help avoid cash shortages that might be more common with fixed monthly payments.
“For a seasonal business, this can be a lifesaver,” said Andrew Rafal, president of Bayntree Wealth Advisors. “If they have a down month, they won’t have to cover the fixed cost of a small business loan.”
Overall, a business loan can be significantly less expensive than a merchant cash advance. Hecht advised to always check if a business loan is available before taking an advance. For example, he says some merchant cash advance users might qualify for SBA-backed loans carrying a rate of 7%.
“A cash advance from a merchant can be tempting, but there are many pitfalls that can leave small business owners in dire financial straits,” Kiisel added.
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Funding speed: Speed is an important advantage of advances. Advances can often be requested online and funds deposited into the company’s account within 24 hours. In comparison, weeks can pass between when a bank loan is applied for and when the borrower is approved and the money is available.
Borrowing limits: A merchant cash advance can provide amounts from a few thousand dollars up to $250,000 or more. SBA-backed loans, on the other hand, can be as high as $5 million.
Borrower Requirements: Credit history is not important with a cash advance. A business may be approved for an advance based on their credit card transaction history. A bank business loan, however, will generally require the business owner to have a personal credit score of around 700.
The owner will often have to personally guarantee the loan and may have to provide additional collateral. For example, a loan to purchase factory equipment may be secured by the equipment or by a lien on the factory building.
The bottom line
Merchant cash advances can be faster, involve less paperwork, and be accessible to businesses with less credit history. However, they can cost significantly more than business loans, making loans preferable for borrowers who have the time and credit to obtain them.
“What we’ve found is that most customers can usually take the time to wait a week or two to understand their offers and get competitive offers from a wider range of lenders across a variety of ranges of products,” said Hecht of Fundera. “That said, some customers don’t want to wait.”
Think a loan is right for you? Check out Business News Daily’s guide to choosing the best loan for your business.