APR vs Factor Rate: Understanding the Difference

APR vs Factor Rate: Understanding the True Cost of Business Funding

When shopping for business financing, you'll encounter two primary ways lenders express costs: Annual Percentage Rate (APR) and Factor Rate. Understanding the difference—and how to compare them—is essential for making informed borrowing decisions and avoiding expensive mistakes.

What Is APR (Annual Percentage Rate)?

Definition and Components

APR represents the total annual cost of borrowing expressed as a percentage. It includes:

• ●Interest Rate: The base cost of borrowing
• ●Fees: Origination fees, closing costs, processing fees
• ●Other Costs: Any charges related to obtaining the financing

How APR Works

APR is designed to let you compare loan costs across different products on an equal footing. The calculation accounts for:

• ●The total amount borrowed
• ●All fees charged
• ●The loan term
• ●Payment frequency

Example APR Calculation:

• ●Loan Amount: $50,000
• ●Interest Rate: 10%
• ●Origination Fee: $1,500 (3%)
• ●Term: 3 years

Without the fee, you'd pay ~$8,100 in interest. With the $1,500 fee factored in, the APR becomes approximately 12.2% rather than the stated 10% interest rate.

APR Key Characteristics

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What Is a Factor Rate?

Definition

A factor rate is a decimal figure that represents the total amount you'll repay for every dollar borrowed. Unlike APR, it's a fixed multiplier applied to the principal—the cost doesn't decrease if you pay early.

How Factor Rates Work

The calculation is straightforward:

Total Repayment = Advance Amount × Factor Rate

Example:

• ●Advance: $50,000
• ●Factor Rate: 1.35
• ●Total Repayment: $50,000 × 1.35 = $67,500
• ●Cost of Capital: $17,500

Factor Rate Characteristics

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Converting Factor Rate to APR

Why Conversion Matters

Because factor rates and APR measure costs differently, comparing a product with a factor rate to one with an APR requires conversion. This is crucial for true cost comparison.

Conversion Formula

Estimated APR = ((Factor Rate - 1) ÷ Loan Term in Years) × 100

However, this simplified formula doesn't account for payment frequency. A more accurate approach:

For Daily Payment Products: APR ≈ ((Factor Rate - 1) × 365) ÷ (Term in Days × (1 + Factor Rate) ÷ 2) × 100

Conversion Examples

Critical Note: The shorter the term, the higher the effective APR for the same factor rate.

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Detailed Comparison

Side-by-Side Analysis

Visual Example: $50,000 Funding

12% APR Loan (2-year term):

• ●Monthly Payment: ~$2,354
• ●Total Repayment: ~$56,500
• ●Cost of Capital: ~$6,500
• ●Early Payoff (12 months): ~$53,100 total (saves ~$3,400)

1.35 Factor Rate (Expected 12-month term):

• ●Total Repayment: $67,500
• ●Cost of Capital: $17,500
• ●Early Payoff (6 months): Still $67,500 (no savings)
• ●Equivalent APR: ~50-60%

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Which Funding Types Use Which?

APR-Based Products

Factor Rate-Based Products

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Why Factor Rates Exist

The Funding Company Perspective

MCAs and similar products use factor rates because:

1. ●Legal Classification: MCAs are purchases of future sales, not loans—APR disclosure requirements may not apply
2. ●Risk Pricing: Higher-risk funding justifies non-traditional pricing
3. ●Simplicity: Factor rates are easy to calculate and explain
4. ●Certainty: Funders know exactly what they'll receive

The Business Owner Perspective

Understanding this helps you:

• ●Recognize when you're paying premium prices
• ●Compare options more accurately
• ●Negotiate better terms
• ●Choose the right product for your situation

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True Cost Calculation Guide

Step-by-Step Comparison Process

Step 1: Identify the Cost Structure

• ●Is it quoted as APR or factor rate?
• ●Are there additional fees?

Step 2: Calculate Total Cost

For APR products:

• ●Use loan calculator with term and payment frequency
• ●Add any fees

For Factor Rate products:

• ●Principal × Factor Rate = Total
• ●Add any fees

Step 3: Calculate Cost Per Month

Example Comparison: $100,000 Funding

Option A: Bank Term Loan

• ●Amount: $100,000
• ●APR: 12%
• ●Term: 3 years
• ●Monthly Payment: $3,321
• ●Total Repayment: $119,556
• ●Total Cost: $19,556

Option B: Online Short-Term Loan

• ●Amount: $100,000
• ●APR: 30%
• ●Term: 18 months
• ●Monthly Payment: $6,543
• ●Total Repayment: $117,774
• ●Total Cost: $17,774

Option C: MCA

• ●Amount: $100,000
• ●Factor Rate: 1.35
• ●Expected Term: 10 months
• ●Total Repayment: $135,000
• ●Total Cost: $35,000
• ●Effective APR: ~70%

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When Higher-Cost Funding Makes Sense

Despite higher costs, factor-rate products can be worthwhile when:

Speed Is Critical

Opportunity ROI Exceeds Cost

If the funding generates returns exceeding the cost:

• ●Marketing campaign expected to generate 3x return
• ●Inventory purchase with 40%+ margin
• ●Equipment that increases productivity by 50%

No Other Options Available

For credit-challenged businesses:

• ●Fast funding may be the only option
• ●Cost is secondary to survival
• ●Use as bridge while improving qualifications

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Red Flags and Protection

Warning Signs

• ●Factor rates above 1.50
• ●Refusal to explain total repayment
• ●Hidden fees not in the factor rate
• ●Pressure to accept without comparison
• ●Unclear repayment terms

Protective Questions to Ask

1. ●"What is my total repayment amount?"
2. ●"What is the effective APR?"
3. ●"What fees are NOT included in the quoted rate?"
4. ●"Is there any benefit to early payoff?"
5. ●"Can you provide a complete cost breakdown?"

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Summary: Making the Right Choice

Quick Decision Framework

Key Takeaways

1. ●APR shows annual cost; factor rate shows total cost
2. ●Converting between them requires knowing the term
3. ●Early payoff benefits APR products, not factor rate products
4. ●Higher cost doesn't always mean wrong choice—context matters
5. ●Always calculate total dollars out of pocket

Understanding these cost structures empowers you to make informed decisions and avoid overpaying for capital. The cheapest option isn't always the best option, but you should always know exactly what you're paying.