Short-Term Loans, Merchant Cash Advances, & APRs

Small business owners searching for a merchant cash advance (MCA) or short-term business loan (STL) are often surprised to learn that their capital has come with a very high effective annual percentage rate (APR).

The fact that your cash advance might have an effective APR reaching into the triple digits can be a big surprise. After all, that’s a very large number. You may be wondering how these funders get away with issuing such expensive loans or advances.

It’s easy: they don’t disclose the APR.

The question of whether or not funders should have to disclose APRs is hugely debated in the lending world. Merchant cash advance and short-term loan providers say that APRs are unnecessarily confusing and misleading. Everybody else says that APRs are useful for making apples-to-apples comparisons and that not disclosing APRs is misleading.

Meanwhile, merchants just want affordable capital.

Here’s the thing: APRs are confusing. MCAs and STLs have completely different structures than traditional installment loans, and shoehorning an estimated APR out of that structure can lead to confusing results. But these rough APR estimates are also useful for apples-to-apples comparisons… provided you know how to interpret the APR.

It’s pretty clear: when you’re looking for a loan or advance, you’ll want to get an estimated APR for comparison’s sake. But to effectively make comparisons, you need to understand what APRs are for, how they work, and what their limitations are.

What Is An APR?

The APR—annual percentage rate—is a number that communicates the rate of borrowing over one year. For installment loans (the most commonly used loans, which carry interest rates), this number is a reflection of the interest rate plus all the fees included in the loan. For a list of fees commonly charged in addition to interest, see our guide to Understanding Small Business Loan Fees.

This number is important because lenders often structure their loans differently. One might charge an origination fee whereas another doesn’t, or they might have different interest rate structures. The APR is a way of communicating the interest rate–plus fees–in a single, easily comparable number.

The APR works well for comparing term loans to other term loans. Here’s an example:

Which one is actually the better deal? Despite the higher interest rate, Loan B actually has a lower APR than Loan A. If a merchant were deciding between these two loans, they would probably want to choose Loan B.

However, Loan B may not always be the best choice. The term length has an effect on the APR as well. Here are loans with the same interest rates and extra fees, but with a term length of 10 years:

As you can see, Loan C is now the better choice in this scenario. Despite the fact that it comes with more fees, this loan has a lower APR because the fees are spread out over a longer period of time.

But what if you had a choice between Loan A and Loan D? Although Loan D still has a lower APR, it has a higher overall cost of borrowing. You’ll have to decide if you want lower monthly payments ($1,957 vs. $1,187 per month) or a lower overall cost of borrowing ($20,932 vs. $42,442 in fees).

Evidently, APR is not the only metric to consider when deciding on a loan. The same principal applies to merchant cash advances and short-term loans.

Calculating APR On Merchant Cash Advances & Short-Term Loans

The obvious problem with getting an APR out of a short-term loan or merchant cash advance is that these products don’t use interest rates.

Instead, they charge a factor rate. To determine the borrowing fee, which is called a “fixed fee,” they’ll multiply the factor rate by the borrowing amount. For example, you might get a loan with a factor rate of x1.28 (also sometimes written as 28%). That means you’ll have to repay your lender $12,800 ($10,000 x 1.28). In other words, your fee is 28% of the borrowing amount.

If you get anything out of this article, let it be this: factor rate is not the same thing as interest. With a factor rate, the fee is calculated once based upon the original borrowing amount. With interest, the fee is accrued over time by calculating a percentage of the remaining principal until the loan is paid off.

For the above reason, you cannot technically calculate an APR on a merchant cash advance or short-term loan. However, you can still estimate it. To differentiate, an estimated APR is typically called the “effective APR.”

Here are a few examples to illustrate the role of APR in a short-term loan:

Non-intuitive as it may be, the APR on Loan E is double the APR on Loan F, despite the fact that they both carry the same total financing cost. Because Loan E is paid off over a shorter period of time, the equivalent interest rate would be higher.

For financing with short term lengths, the effective APR does not tell you how much you are going to pay, it tells you how fast you will be paying it. In other words, the effective APR gives you the rate of borrowing; it does not tell you the cost of borrowing. A high effective APR means you’ll be repaying the loan or advance very quickly; a lower effective APR means the opposite.

Obviously, in the example above, the borrower will want to choose Loan F (unless they want to get it paid off as quickly as possible). But what if it weren’t as cut-and-dry as the example above? If you’re requesting funds from a lender, they might give you a couple different options:

Some lenders may offer two loans to you: one with a longer term length but a higher factor rate, and one with a shorter term length but a lower factor rate.

In this example, Loan G has a higher effective APR, but a lower overall cost of borrowing. On the other hand, Loan H has smaller monthly payments and a lower effective APR, but a higher overall cost of borrowing. Which is the better loan? It depends on what the merchant is looking for.

How To Compare MCA & STL Offers

To fully understand the cost of the loan, effective APR is not enough; you will need to evaluate additional metrics as well:

• The Total Financing Cost: How much do you have to pay in fees? This should include the fees calculated by the factor rate, as well as any additional fees (such as an origination fee).
• The Monthly Payment: About how much are you paying per month? Because STLs and MCAs have varying payment schedules (some require payments each business day whereas others require payments each week or month) you will be able to compare loans on an even playing field if you calculate how much payments are per month.
• The Cents On The Dollar Cost: How much do you have to pay in fees per dollar borrowed? For example, the borrower would have to pay $0.28 per dollar borrowed for Loans E and F in the table above.
• Prepayment Discounts & Double Dipping Policies: Does this funder give you a discount if you repay early? Or do they participate in double dipping?

The offer that is best will depend on the merchant’s needs. Do you need lower monthly payments? Or do you want to save as much money as possible? Do you anticipate that you’ll need more funds in the near future? (If so, you’ll want to find a funder that doesn’t double dip.)

A good funder will provide this information up-front so that you can make an informed borrowing decision. For example, some merchant cash advance and short-term loan providers have created a SMART Box, a standardized method for disclosing rates and fees, which includes all the information listed above, including the estimated APR.

However, if your provider does not disclose the effective APR, you can use the following calculators to get an estimate.

MCA and STL Loan Calculators

These calculators can be used to understand the full picture of a loan or advance. They’ll provide an estimation of everything you need to know to make an informed decision, including the effective APR, the cost of borrowing, and the periodic payment.

Head over to our Merchant Cash Advance Calculator and Short-Term Business Loan Calculator pages for more information on these calculators.

Final Thoughts

APRs can be an important metric to consider when evaluating merchant cash advance or short-term loan offers, but should be used in conjunction with other metrics as well.

In addition to the APR, you should consider the total financing cost, the cents on the dollar cost, the monthly payments, and whether or not the funder has a prepayment discount. Although this type of funding can be confusing at first glance, you will be able to make informed borrowing decisions by analyzing each of these metrics and evaluating what is most important to the health of your business.