Factor rates explained
Cash flow is – and will always remain – king in the world of small business.
During periods of opportunity, a cash flow boost can help businesses grow or take advantage of a limited time opportunity.
During lean times, small businesses may need to access credit to stabilise the ebbs and flows of their cash flow and enable them to pay staff, suppliers and other operational costs.
While there are a variety of pricing conventions used in business lending, this article looks into the detail of factor rates.
What is a factor rate?
A factor rate tells you the actual cost of the money you are borrowing.
For example, a factor rate of 1.2 on a loan of $100,000 (including the origination fee) means the money will cost you $120,000 – or 1.2 times the borrowed amount.
Unlike interest rates, which are expressed in percentages, factor rates are usually given in decimal figures.
What do you need to know about factor rates?
- Factor rates tell you the cost of the money you are borrowing in a clear dollar amount.For example, do you know what your $500,000 mortgage costs over 30 years at 5 per cent annual interest? Tip: it’s around $1 million, which would give your mortgage a factor rate of 2.
- As a fixed term product, it doesn’t matter if you pay out the loan early – there are no penalties, nor do you get a benefit.
How are factor rates calculated?
Factor rates usually vary from 1.08 to 1.40. For business owners, the rate you get will depend on multiple factors, including:
- The length of time you’ve been in business.
- The type of industry you operate in.
- Your average monthly sales and how consistent sales are.
- The term of your loan.
- Whether the loan is secured by property or other assets.
The factor rate is calculated by dividing the financing cost by the loan amount. This means that factor rates can sometimes make more expensive lending initially appear cheaper.
Also, the full amount of the interest is charged to the principal when the loan or advance is originated.
This means you’re paying the interest upfront, so the interest charges will remain the same and aren’t dependent on the length of the loan even if the loan is repaid early.
What are factor rates used for?
Factor rates are used to meet short-term cash flow needs within a business.
There are multiple scenarios where a business would need a cash flow boost, including:
- To take advantage of a limited time bulk discount to purchase additional or new inventory ahead of a busy season.
- An injection of cash that allows you to continue operating while waiting for for a large project payment.
- Realising an opportunity for growth when you need to purchase additional equipment or inventory to meet demand.
- To cover wages for additional casual staff during a busy time.
- Cash flow that will help you complete a critical project.