Factor Rate vs APR: How to Compare Small Business Financing

When you're comparing financing options for a business — a merchant cash advance with a factor rate on one side and a bank loan quoted with an APR on the other — it can feel like comparing apples and oranges. Both describe cost, but they do it in different ways. A factor rate multiplies your principal to give a total repayment amount, while APR expresses the yearlyized interest cost and includes fees in many cases. For a fair comparison, you need to convert factor-rate terms into an APR-equivalent, taking repayment schedule and term length into account.

Why this matters: lenders who use factor rates often provide fast, flexible capital that repays through daily debits or a share of sales. That repayment pattern accelerates principal return and can dramatically increase the effective annual cost compared to a longer-term fixed loan. APR, on the other hand, assumes a consistent annualized cost for scheduled repayments and is standardized for disclosure in many countries, which makes it easier to compare long-term loans.

Here's the practical difference with an example:

1. Loan A: $10,000 with a factor rate of 1.25 → Total repayment $12,500.
2. Loan B: $10,000 bank loan with 12% APR for 12 months → Payments scheduled monthly.

At a glance Loan A's cost is $2,500 and Loan B's interest is roughly $1,200 in the year, but Loan A may be repaid in six months via daily debits, which raises its effective annual cost far above 25% when the short term is annualized. To make a fair comparison, you must convert both into the same metric — usually APR — based on realistic repayment timing.

How to convert a factor rate to a rough APR-equivalent (beginner method):

• 1) Calculate total cost: Multiply principal by the factor rate to get total repayment, then subtract principal to get finance charges.
• 2) Estimate the term in years: Based on your expected repayment speed (e.g., 6 months = 0.5 years).
• 3) Use a simple APR approximation: APR ≈ (finance charges / principal) / term. Multiply by 100 to get a percent.

Example: $10,000 at factor rate 1.25 repaid in 6 months.

1. Total repayment = $12,500 → finance charge = $2,500
2. Term in years = 0.5
3. APR ≈ ($2,500 / $10,000) / 0.5 = 0.5 = 50% APR

This is a simplified approach and tends to understate APR for cash-flow-based repayment because daily or sales-based collections place the lender at less risk and can accelerate repayment. A more accurate APR calculation uses time-value-of-money formulas (internal rate of return) that account for the timing and size of each payment.

Other considerations when comparing the two:

• Fees and hidden costs: APRs usually include many fees, but lenders can hide fees in factor-rate structures. Ask for a full fee schedule.
• Repayment flexibility: Some factor-rate products reduce payments when sales fall; bank loans often do not.
• Prepayment: Does the lender charge penalties if you repay early? Factor-rate lenders might still expect the full factor amount unless contractually agreed otherwise.
• Security: Bank loans often require collateral or personal guarantees; merchant cash advances may rely on sales streams or be unsecured but use automated collections.

Best practices when comparing offers:

• Ask every lender to spell out the total dollar amount you will repay and the exact timing of the payments.
• Request an APR-equivalent or use an online APR calculator with the payment schedule the lender provides.
• Model worst-case and best-case sales scenarios if repayment is tied to revenue, to see how cash flow will be affected.
• Factor in non-financial factors such as speed of funding, relationship benefits, and how flexible the lender is on terms.

In friendly terms: think of a factor rate as the sticker price you see on a product and APR as the product's yearly operating cost. Both tell you something useful, but to choose wisely you’ll want them in the same language — and that usually means converting factor rates into an APR-equivalent or otherwise comparing total dollar cost based on realistic repayment timing.