Applying for a business loan involves prudently analyzing the different options and considering all the factors involved, including the upfront and long-term costs. Depending on the industry, and the type of loan you’re looking for, you’ll have a variety of options and features to compare.
A key difference all owners should be aware of when it comes to business financing is whether interest or factor rates are applied to the amount. To determine the optimal loan choice, it is critical to understand how these different types of interest apply. Equipped with this information, you can determine the best financial course of action.
What Is An Interest Rate?
Interest rates are a percentage applied to the amount lent. It is the amount paid by the borrower for access to the funds of the loan. Interest application differs based on the type of loan, though it can be broken into fixed and variable rates.
This type of interest is common to term loans, where the loan is issued as a lump sum. The loan sets forth a schedule that determines payment. Fixed interest sets a percentage amount, where each payment goes in part to the interest with the remainder applied to the principle. This is the lower risk option since the payment amount is set and unchanging.
Also referred to as adjustable or floating interest rates, variable rates can be applied to regular personal loans, car loans and mortgages. Unlike fixed rates, variable rates adjust over time as they fluctuate based on the Canadian Prime Rate.
For example, if you have a variable rate of prime – 0.5%, and the prime rate is 2.45%, it means you will pay an interest of 2.45% – 0.5% = 1.95%. This makes the variable-rate riskier than the fixed-rate, as the payment amounts can change according to the volatility of the prime rate.
Types Of Interest Rates
Interest comes in different types, most often defined by two terms, APR and AIR. In order to understand how these figures apply to debt, it is important to learn what sets the two types apart from one another.
Short for annual percentage rates, this is the more comprehensive term. It refers to the interest charged by lenders, determined annually. The metric is straightforward; a percentage of the principal value of the loan. The actual amount is calculated based on a range of criteria, including the periodic interest, total loan principal amount, monthly payment amount, and time remaining for repayment. It also considers any fees or interest over the full course of the loan.
This type of interest is common for all types of loans, including cash advances, credit lines, and credit cards. The formula is as follows:
APR = [(Total Interest + Fees) / (Principle Amount) / (Total Days In The Term) * 365] * 100
APR is one of the more complex types of interest, a more straightforward way to term interest, is called AIR.
An acronym for annual interest rates, this is a simpler way to calculate the loan interest. Lenders determine this amount by taking the yearly interest owing and dividing the amount of the loan. The result is then divided using the repayment term length. It’s worth a note that this is only a simplified method of calculation, the lender determines the actual figure using various other metrics. These include credit score and debt-to-income ratio. The formula for AIR is:
Assuming: $10,000 loan with $1,000 interest over a course of two years.
AIR = (1/Time)*(Total Cost/Principle – 1)*100
= (1/2)*(11,000)/10,000 – 1)*100
What Is A Factor Rate?
Factor rates refer to the price of borrowing money — the decimal representation of the amount the lender charges for the loan. Though similar to interest rates, it is applied exclusively to the principal amount borrowed. Unlike interest, the factor rate is a set amount that is calculated at the beginning of the loan period.
How Does A Factor Rate Work?
Factor rates are calculated by multiplying the loan amount by the factor rate itself. The combined total of those values is the amount charged to the borrower. These are more common on certain types of loans, where the service of borrowing is the focus rather than interest gained on the amount loaned.
For example, let’s say that you are borrowing twenty thousand dollars at a factor rate of 1.20. This is all the information required to determine the amount you will need to repay, a total of twenty-four thousand dollars.
Loan amount = $20,000
Factor rate= 1.20
Total owing = $20,000 * 1.20 = $24,000
How To Convert A Factor Rate To An Interest Rate?
In order to determine whether you are getting the best rate on a loan, it helps to have figures in terms of both factor rate and annual interest. You convert the factor rate to annualized interest in four steps, as follows:
- Multiply the loan amount by the factor rate to get your total amount to be paid back in dollars.
- Take your total payback amount and subtract the amount you received upfront, the advance amount. This figure is the price of the advance.
- Take the cost of the advance and divide it by the advance amount (not the total payback amount). The result is the cost in percentage.
- Take the percentage and multiply it by 365 (the days in a year). Divide this by the projected repayment term in days. This provides the annual rate of interest.
For example, consider the example from above and assume it has a repayment term of three years.
Loan amount = $20,000
Factor rate= 1.20
Term = 2 years = 730 days
Total owing = $20,000 * 1.20 = $24,000
- $20,000 * 1.20 = $24,000 total payback amount
- $24,000 – $20,000 = $4,000 price of advance
- $4,000 / $20,000 = 0.20 = 20%
- 0.20 * 365 = 73
73 / 730 repayment days = 10% annualized rate of interest
Pros And Cons Of Interest Rates vs. Factor Rate
When determining the optimal approach to borrowing, it is important to weigh the differences between these two approaches.
Pros: Interest Rate
Among the benefits of choosing a loan with an interest rate are:
- Typically lower cost borrowing relative to a factor rate arrangement
- Early repayment offers the opportunity to save on the total repaid amount
- Variable-rate loans can result in lower amounts paid than originally projected
Cons: Interest Rate
Interest rate arrangements are not without drawbacks, among which are:
- Financial consequences of missing scheduled payments
- Final borrowing price is harder to predict when weighed against factor rates
- Fixed payments follow a rigid schedule and have a significant impact on credit
Pros: Factor Rate
As with interest rate arrangements, factor rate loans come with a set of benefits and downsides. The perks include:
- The final, real cost of borrowing is established upfront
- Lacks the rigidly fixed term of an interest-based loan
- The cost of financing will remain the same if it takes longer to repay than expected
Cons: Factor Rate
Though there are many benefits to factor rate arrangements, specifically when it comes to financial considerations. Among the negative features of factor rates are:
- In almost all cases, it costs more to borrow through a factor rate arrangement than with interest-structured financing
- There is no benefit of early repayment on the loan because the amount is fixed upfront
Determining the ideal approach to borrowing depends on your financial situation. If it is plausible to make regular payments, then interest-based is usually a way to save. However, if the business lacks a predictable stream of income, then factor rate loans would less stress on scheduled payments.
Who Charges Interest Rates?
Interest rate structures are offered at the vast majority of lending facilities. These range from major financial institutions to small- or medium-sized alternative lenders. Depending on the business, the terms available on interest rates and the qualification criteria, differ.
Though there are 88 recognized banks in Canada, the market is cornered by five major players. Colloquially referred to as the Big Five, these major lenders include TD, BMO, RBC, CIBC, and Scotiabank. These institutions charge interest on loans; though, because of the high participation rates, interest rates and fees are the lowest on the market. In order to offer these competitive rates, these banks have the highest qualification requirements. For those with solid credit and little debt, the interest rate loans at banks are often preferred approaches to loans.
Similar to banks in some ways, credit unions are entirely independent companies. In Canada, there are 231 Credit Unions, though 219 of these are owned by the Desjardins Group and operate mainly in Ontario and Quebec. Unlike banks, these institutions have unique regulations for offering loans. Most often, this involves having a membership at the credit union itself. The rates are usually a bit higher than with banks, given the relatively smaller number of participants. However, those with poorer credit are more likely to get a loan at a credit union than a bank, particularly if the other metrics, like income and debt, are decent.
Finally, for those whose low credit precludes loans through standard financial institutions, alternative lenders are a popular option. These private companies operate across Canada and offer loans to businesses and people with subprime credit. The loans have less stringent requirements for approval. Also, the lenders are usually willing to use alternative metrics to assess risk. These factors include job stability, income, and debt levels. Because of the nature of alternative lenders, and the extra risk of lending to borrowers with subprime credit, the interest rates are highest at alternative lenders.
Who Charges Factor Rates?
While it is not as common as interest loans, there are still financial agreements available with these terms. The most common is called a merchant cash advance which can be accessed across Canada at various different vendors.
Merchant Cash Advance
Factor rates refer to an advance issued with a fixed cost for the service. Usually, the loans range from at least $5,000 to $500,000. In some situations, the loans can go as high as one million dollars, though this is not very common. To get a merchant cash advance, be sure to vet the business. Regulations that cap the rates on loans don’t apply to this type of factor rate loan. As a result, the cost of services can be extremely steep.
In order to qualify for a merchant cash advance, there are certain criteria to meet, including:
- Having a business headquartered in Canada
- Having been in operation for a fixed amount of time (at least six months)
- Operating a commercial location rather than a digital commerce platform
- Generating a set amount of sales via credit and debit
The application requires government-issued identification, business documentation including the lease and merchant identifier, banking information, and sales records. The more money being borrowed, the more stringent the criteria.
When To Use Cash Advances
Cash advances are best when the money borrowed is needed right away and there is no way to follow the repayment schedule that an interest rate loan would set forth. For example, you have a purchase order valued at $2,000,000. In order to produce the items for sale, you require $1,000,000. It will take three months to generate the product and complete the sale.
If you used an interest-based loan, you would have set monthly payments to make. Additionally, the amount remaining on the debt is gathering interest. If you are unable to make those payments without the proceeds of the sale, you risk defaulting on the loan, incurring fees and damaging your credit.
With a factor rate loan, you are likely to pay between 20 percent and 40 percent of the principal amount, though there is no set term for repayment. After three months, the business could repay the 1.2 million and retain the difference of $800,000. Bear in mind that this does not help build business credit because it is not reported to the credit bureau. As such, it makes more sense as a first step in the production chain, only once there is a set purchase order.
Though both are ways to borrow money, there are major differences between factor- and interest-rate loans. There is an applicable time for both approaches to financing. Interest-based loans are the preferred way to go. Established businesses with reliable cash flow benefit from interest loans.
Newer companies that rely on immediate funding to fulfill a sale can benefit from factor rate loans. Regardless of the type of loan chosen, the key to success is thorough research. Use a loan comparison tool to see the funding options available so, whether factor or interest, you can be sure your business is making the best possible long-term decision.