When you’re running a small business, your cash flow can be sporadic early on. It can be hard to come up with money for the things you need while you’re growing and scaling a young business, so it’s normal for many small business owners to take out business loans.
Most legitimate business loans are obtained through traditional banks. However, it can be challenging for newer companies to get approved for such a loan.
In this situation, many small business owners start looking into alternative options. One of the options you’ll come across is something called a “merchant cash advance loan.” This type of loan is offered by private companies that are not banks and are not regulated as a bank.
Before we go into exactly why merchant cash advances don’t work in your favor, we’re going to cut to the chase: it’s kind of like the business loan equivalent to a consumer payday loan. It may be easy to get, but some side effects are high-interest rates, never-ending payments and other factors that could sink your business financially.
It’s a short-term solution with long-term negative implications. Of course, merchant cash advance providers don’t tell you that on their websites and marketing materials. The companies that offer merchant cash advance loans make it sound like it’s a great deal, but as you are learning, it’s not.
How Do Merchant Cash Advance Loans Work?
Merchant cash advances are geared primarily toward businesses where a lot of your income is coming from credit card and debit card sales – think retail shops and restaurants. It’s not technically a loan; it’s a cash advance that you pay back later. You get cash up front, and the merchant cash advance company gets a portion of your future revenue.
Typically there are two ways that a merchant cash advance can be structured. In one model, you get the cash up front and pay it back later with credit card and debit card sales. In the alternate model, you get cash up front, then pay for it with fixed daily or weekly debits from your bank account using Automated Clearing House (ACH) withdrawals.
The ACH model has become increasingly popular in recent years, partly because the companies offering the cash advances can market them to businesses that aren’t reliant on credit card and debit card sales. Under the ACH model, your small business keeps paying daily or weekly payments, plus fees and interest until the merchant cash advance has been paid off in full.
The total fees you’ll pay is determined by your ability to repay the merchant cash advance. The company uses risk assessment to determine this. They assign a factor rate typically ranging from 1.2 to 1.5, with higher rates reflecting increased risk.
To calculate your total repayment amount, you multiply the amount of cash you received by the factor rate. With a factor rate of 1.4, a $75,000 advance will ultimately cost your small business $105,000. That’s $30,000 in extra fees. That’s astronomical.
In the credit card sales model, a percentage of your business sales will go to the merchant cash advance company. The repayment period can be anywhere from three to twelve months. The speed at which you’re able to repay the loan can drive your annual percentage rate (APR) on the cash advance into the triple digits.
Your sales will inevitably fluctuate, and because you’re paying via a percentage of your sales, the time it takes to pay back the loan could be either longer or shorter than you initially expected. Usually, it takes longer.
With the fixed daily or weekly withdrawals model, unlike the credit card sales model, your daily or weekly payment will not go down if your business makes fewer sales and generates less revenue. This payment method can be dangerous if your business isn’t doing as well as you had expected.
For the rest of the article, click here.