At face value, a merchant cash advance sounds appealing to many business owners.
Read on to find out if this alternative loan option is a fit for your small business.
A merchant cash advance provides a quick solution for those in need of short-term financial assistance and for business owners who’ve been denied a traditional loan from their local bank. They require very little paperwork, no collateral, and can be approved and funded within a day or two, even for business owners with a low credit rating.
Unfortunately, the convenience of cash advance loans comes with a catch—mostly in the form of exorbitant interest rates and hefty fees. If you’re considering applying for one, make sure you fully understand the downsides of merchant cash advances.
Higher Fees Than Other Alternative Loan Options
If you plan to apply for a merchant cash advance, expect to pay higher fees than you would for alternative loan options.
Unlike most loans that express their interest rates as an annual percentage rate, merchant cash advances are priced with a factor rate or buy rate. In order to figure out the true cost of the cash advance loan, you multiply the advance, or the amount borrowed, by the factor rate. So if you have a factor rate of 1.3 on a $100,000 advance, the total payback amount comes out to be $130,000.
The difference is, when a factor rate is used, the interest is charged on the principal during origination of the cash advance loan. With most loans, the interest accrues on the principal amount as payments are being made and the principal gets smaller.
These cash advances do offer some flexibility in that the amount you pay each day will vary. As you pay back the loan with a set percent of your daily credit card sales, this can be good news for businesses with seasonal sales volumes, since it means you’ll pay back more on the days your company has higher sales, and pay less on slower days.
Reduced Amounts of Cash Flow
There’s no grace period when it comes to a merchant cash advance. Instead, you begin repaying your debt right away. While you are able to repay less money on slower days, the costs are still cutting directly into your cash flow.
The companies that are best suited for a merchant cash advance are those who have a rapid business cycle. This can be hurtful for businesses that need the extra working capital or don’t have a wide enough profit margin to hand off this additional revenue.
Distressed companies may need to take out another advance to help cover the costs of the original, sending many into a trap of continued borrowing.
Since they don’t require a lot of paperwork and ask for no collateral, lenders are taking a big risk providing you with a cash advance. To make sure they get paid, lenders have restrictive stipulations for your business. For example, you may be prohibited from making any changes to your credit card processor until after the advance has been repaid.
Occasionally, businesses may encourage customers to pay cash in order to avoid credit card fees or giving a percentage to the MCA providers. Encouraging cash payments, through discounts for example, could be restricted by merchant cash advance lenders.
The cash advance business is a competitive one, so make sure you do your research and compare the prices of each lender before you come to a decision. Since cash advances are extremely expensive, you want to make sure the loan is worth the cost, and that you’ll have the ability to cover both the costs of your business and your loan.
About the Author
Thank you to Fundera's Meredith Wood for contributing to the SmartBiz Small Business blog. She is the Head of Content and Editor-in-Chief at Fundera, an online marketplace for small business loans. Prior to Fundera, Meredith was the CCO at Funding Gates. Meredith manages columns on Inc, Entrepreneur, HuffPo and more, and her advice can be seen on Yahoo!, Daily Worth, Fox Business, Amex OPEN, Intuit, the SBA and many more.