What is the difference between APR and a factor rate?

How do a factor rate and an APR compare?

Neither number is wrong. They answer different questions, and an offer that states only one leaves the other for you to work out.

How does a factor rate work?

You multiply the amount by the factor rate to get the total repayment. A factor rate of 1.30 on $10,000 means you repay $13,000. The cost is $3,000, or $0.30 on each dollar.

There is no interest that builds up over time. The cost is set on day one. That is why paying early often saves nothing on a factor-rate deal, and why the FTC's staff noted that some small business owners wrongly assumed they would save money by repaying products like MCAs early. Whether your contract has any early-payoff discount is a question for the contract, not the factor rate.

Two other things hide behind the factor rate:

• Fees. If fees come out of the amount before it reaches you, you receive less than the number on the offer while still repaying the full total.
• Payment schedule. The same total repaid by daily debits over six months is a heavier load than the same total spread over twelve.

What is an APR, and why does time matter?

Federal Regulation Z defines the annual percentage rate as "a measure of the cost of credit, expressed as a yearly rate, that relates the amount and timing of value received by the consumer to the amount and timing of payments made." The two words that matter are amount and timing.

Think of it as a price per year for the money you are using. If you pay $3,000 to use $10,000 over twelve months, that is one price per year. If you pay the same $3,000 and the money is repaid in six months, you had it for half as long, so the price per year is far higher.

One caution on scope. The FTC's staff has noted that the Truth in Lending Act generally does not reach small business financing. That is why business providers describe cost in so many ways, including APR, interest rate, fees, factor rate, and total cost of capital, and why the staff said it made apples-to-apples comparison hard.

What does the same factor rate look like as an annual rate?

Example only. These numbers are invented to show the math. They are not offers, typical terms, or rates from BreadRoute or any provider.

Take $10,000 offered at a 1.30 factor rate with no fees. The total repaid is $13,000 in every row. Only the time changes. The estimated annual rate below uses the same method as our working capital cost tool: it finds the rate per payment that makes your equal payments add up to the cash you received, then multiplies by the number of payments in a year.

The dollar cost never moves. The annual rate falls from about 217% to about 51% because you hold the money longer. Add $300 in fees taken from the funding and the 6 month row becomes $9,700 received, $13,000 repaid, and about 123%.

Now compare it with a term loan, using an invented rate. A $10,000 loan at a 24% APR repaid in twelve equal monthly payments costs about $1,347 in interest, with payments near $946. A 1.30 factor rate repaid over twelve months costs $3,000. The loan's rate looks large and its cost in dollars is much smaller. The factor-rate offer looks small and costs more than twice as much. Neither figure alone tells you that.

The tool below accepts your own amount, factor rate, fees, and schedule, and shows the total cost, a cost per dollar, and the estimated annual rate. It is a comparison tool, and a provider's disclosed APR can differ because of how it counts fees, timing, and payments.

Which states require an estimated APR, and how is it figured?

Some states require providers to disclose an estimated annual rate with a specific commercial financing offer. We read two:

• California. A provider must disclose, at the time of a specific offer and before the deal closes, the total amount of funds provided, the total dollar cost, the term or estimated term, the method, frequency, and amount of payments, a description of prepayment policies, and the total cost expressed as an annualized rate (Financial Code 22802). The state's regulations define "sales-based financing" as financing repaid as a percentage of sales or income, and set out estimating methods for it, including a "historical method" (10 CCR 900 and 930). They also define a "retrospective annual percentage rate" as the actual rate worked out after the contract is fully repaid.
• New York. For sales-based financing, a provider must disclose the total amount, the disbursement amount, the finance charge, an estimated APR, the total repayment amount, the estimated term, and the payment amounts (Financial Services Law 803). The estimated APR is to be calculated under Regulation Z (12 CFR 1026.22) using the estimated term and the projected payments, which in turn come from a projection of your sales.

Two things follow. First, an "estimated" APR depends on a guess about how much you will take in, so it can differ from the rate you end up paying. Second, these laws cover specific providers and transactions, with thresholds and exemptions, and many states have no such rule. Do not assume an offer includes an APR. Ask for the total repayment in dollars either way.

How do I compare two offers that use different measures?

Line them up on the same facts:

1. Cash you receive. The amount offered minus every fee that comes out of it.
2. Total you repay. In dollars, including any fees you pay later.
3. How long and how often. The number of payments, the payment size, and whether debits are daily, weekly, or monthly.
4. What it does to your cash. A daily debit of $103 against a slow week of deposits is a different problem from a monthly payment of $1,083.
5. Early payoff. Whether paying early lowers what you owe.
6. The security. A personal guarantee, a lien, or other claims.

Then compute both numbers for each offer: the cost in dollars and an estimated annual rate. The cheaper offer in dollars can have the higher annual rate, because it is shorter. Which one fits depends on how long you need the money and what your cash flow can carry. If you are comparing an advance with other options, look at merchant cash advance, working capital, and factoring, and read how freight factoring works for the invoice-based option.