For small business owners looking for fast and flexible financing, a merchant cash advance (MCA) can be an appealing option. But while MCAs are easier to qualify for than traditional loans, they can also come with high costs that are important to understand before committing. In this guide, we’ll break down how an MCA works, the costs involved, how to calculate these costs, and some alternative financing options that may offer lower costs for your business.
What is a Merchant Cash Advance?
A merchant cash advance is not technically a loan. Instead, it’s an advance on future business sales. With an MCA, a provider gives you a lump sum of cash in exchange for a percentage of your future credit or debit card sales. Instead of a fixed monthly payment schedule, an MCA repayment varies daily based on your sales. This structure can make an MCA especially attractive for businesses with seasonal sales or fluctuating cash flow.
The flexibility of an MCA allows businesses to repay more during high-sales periods and less when sales are slower. However, this convenience comes with a higher cost than most traditional loans.
How the Cost Structure of an MCA Differs from Traditional Loans
Unlike traditional loans, which typically use an APR (annual percentage rate) to determine costs, merchant cash advances use a factor rate. The factor rate is a fixed multiplier that sets the total amount you must repay. Typical factor rates for an MCA range from 1.1 to 1.5 and depend on factors such as your sales volume, industry risk, and creditworthiness.
For example, if you take out a $10,000 MCA with a factor rate of 1.3, the total amount you’ll repay is $13,000. This factor rate structure can make it challenging to directly compare an MCA with traditional loans, as the effective APR on a merchant cash advance can be much higher.
Calculating the Total Repayment Cost of a Merchant Cash Advance
Let’s dive into an example to clarify the true cost of a merchant cash advance. Suppose you take a $10,000 MCA with a factor rate of 1.4. Here’s how the cost would break down:
- Advance Amount: $10,000
- Factor Rate: 1.4
- Total Repayment: $10,000 * 1.4 = $14,000
In this example, your merchant cash advance costs $4,000 in fees, so you’ll repay $14,000 in total. The total repayment amount is fixed, but since repayment is based on daily sales, the time to repay the MCA varies. This makes it challenging to calculate the effective APR on a merchant cash advance, which can be significantly higher than that of a traditional loan, depending on how quickly you repay.
Understanding Holdback Rates and How They Impact Your Repayment
Another essential part of merchant cash advance repayment is the holdback rate, which is the percentage of your daily credit or debit card sales that goes toward repaying the MCA. Holdback rates typically range from 10% to 20%, depending on your sales volume and the terms of your MCA. The higher your daily sales, the faster you’ll repay your advance, but if sales slow down, repayment also slows down.
For example, if you have a holdback rate of 15% and your daily sales are $1,000, then $150 would go toward repaying your MCA for that day. If sales drop to $500, then the payment for that day would be $75. While this can help businesses manage cash flow during slow periods, it also means that if you have high sales, you could end up repaying the MCA more quickly—leading to a higher effective APR.
Why the Effective APR of a Merchant Cash Advance Can Be High
While merchant cash advances provide quick access to cash, they often carry a high effective APR. Unlike traditional loans, which spread interest over a fixed term, the repayment period for an MCA varies with daily sales. High daily sales can mean rapid repayment, raising the effective APR on the advance.
For example, if you take a $10,000 merchant cash advance and repay $14,000 within six months, the effective APR is much higher than the nominal 40% factor rate suggests. The flexible but rapid repayment structure of merchant cash advances often makes them one of the more expensive financing options available.
Additional Fees to Watch For with an MCA
In addition to the factor rate and holdback rate, a merchant cash advance can come with other fees that increase the cost:
- Origination Fees: Many MCA providers charge an upfront processing fee, typically 2% to 5% of the advance amount.
- Renewal Fees: Some providers allow or encourage renewals, where you take an additional MCA before repaying the first. These can lead to new fees and higher repayment totals.
- Late Payment Fees: While merchant cash advances typically auto-deduct payments, some providers may charge fees if payments fail due to insufficient funds.
Understanding these fees is crucial, as they can quickly add to the cost of your MCA.
Hidden Costs of an MCA on Cash Flow
Because MCA repayments are deducted daily from sales, this can impact your cash flow and limit your ability to pay for other business expenses, like rent, payroll, or inventory. During slower sales periods, daily deductions from your MCA can add strain to your finances. Business owners should consider how MCA deductions will affect overall cash flow to avoid disruptions to regular operations.
Alternatives to a Merchant Cash Advance
Given the high costs associated with a merchant cash advance, it’s worthwhile to explore alternative financing options that may offer lower overall costs:
- Business Line of Credit: A business line of credit allows you to borrow only what you need and pay interest on the drawn amount, which can help manage cash flow more affordably.
- SBA Loans: If you qualify, SBA loans typically offer lower interest rates and longer repayment terms than merchant cash advances, making them a more cost-effective choice for many business owners.
- Traditional Term Loans: Traditional loans from banks or credit unions usually come with fixed repayment schedules and lower interest rates than MCAs.
- Invoice Financing: Businesses that invoice customers can use invoice financing to borrow against unpaid invoices, offering access to cash without the high cost of an MCA.
Tips for Reducing the Cost of a Merchant Cash Advance
If you decide that an MCA is the best fit for your needs, here are some tips to reduce the cost:
- Negotiate Factor Rates: Some providers may offer flexibility in factor rates based on your business’s sales history and credit.
- Compare All Fees: Ask about any fees you don’t fully understand before signing a merchant cash advance agreement to avoid unexpected costs.
- Limit MCA Use to Emergencies: Merchant cash advances are best for short-term emergencies or opportunities, as their high cost makes them less suited for regular financing needs.
Conclusion: Is a Merchant Cash Advance Right for Your Business?
A merchant cash advance offers quick funding and flexible repayment options, but it also comes at a higher cost than many other financing options. By understanding the fees, holdback rates, and potential cash flow impact of an MCA, you can make an informed decision that aligns with your business’s financial health. For some business owners, alternative options like lines of credit or SBA loans may offer more affordable and sustainable financing. We can help you prepare your business to meet the SBA loan qualifications.
Evaluating the true cost of a merchant cash advance and considering all available options will help you determine the best way to fund your business needs without jeopardizing long-term financial stability.