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A coefficient is a multiplier that some lenders use to calculate the total cost of a business loan. This rate is used in place of the annual rate (APR).
Factor rates are most common in bad credits and alternative types of business loans, such as merchant cash advances. These loans are usually short-term and other business loans may come with extra charges that are not common.
Unlike APR, the coefficient does not incorporate a loan fee when determining the loan cost. Factor rates make it difficult to determine the true cost of a factor rate loan. Converting factor rates into annual interest rates makes it easier to compare loan costs.
How do factor rates work?
Factor rates are usually expressed as decimal points between 1.10 or 1.50, multiplying by the amount you are borrowing. The final amount is the cost of the loan that does not include any additional charges that the lender may charge.
How to calculate the coefficient rate
Let’s say you get a loan for $75,000 and the 1.30 coefficient expands over 18 months. Plug in the number and you get $97,500 in total loan costs, multiplying $75,000 by $1.30.
If you want to know the costs charged, subtract the amount borrowed from the total loan cost: $97,500 – $75,000 = $22,500.
Factor rate and interest rate
| Factor rate | interest rate | |
| Borrowing costs | It is represented as a decimal | Expressed as a percentage of loan principals |
| Lender charges included | no | APR includes fees |
| Fixed or variable costs | Fixed prepayment fee | Fixed or variability over the lifespan of a loan |
| Early payoffs save money | No, unless discounts are offered | yes |
| Typical use | Short-term funding | Long-term loans and credit lines |
How to convert factor rates to interest rates
To compare your loan with factor fees and interest rates and ensure you get the most affordable loan, find the annual interest on your factor rate loan.
The method of converting factor rates to interest rates is used using the example loan for $75,000 with a coefficient of 1.30 repayment over 18 months.
Method 1: Long formula
Here is an example of how it works:
- Step 1: $75,000 (amount borrowed) x 1.30 (factor rate) = $97,500 (total loan cost)
- Step 2: $97,500 (Total Loan Cost) – $75,000 (Amount borrowed) = $22,500 (Total Interest Charged)
- Step 3: $22,500 (total interest claim) / $75,000 (amount borrowed) = 0.30 (interest as decimal)
- Step 4:
- a) 0.30 (interest as decimal) x 365 (day of one year) = 109.50
- b) 109.50/547.5 (days for the 18-month period) = 0.20 (annual interest)
- Step 5: 0.20 (annual interest) x 100 = 20% (annual interest)
Method 2: Simplified
This method of converting coefficients to interest rates simplifies the procedure used in Method 1. To do this:
An example of this calculation process is:
- 1.30 (factor rate) – 1.00 = 0.30
- 0.30 x 365 (1 year day) = 109.50
- 109.50 / 547.5 (day of repayment period) = 0.20 (interest as decimal)
- 0.20 (interest as decimal) x 100 = 20% (annual interest rate)
Compare factor rates with interest rates
If you pay it in 18 months, you can compare costs now that you know a $75,000 loan with a coefficient of 1.30 converted to a 20% interest rate at a coefficient rate of 1.30.
A $75,000 loan with a factor of 1.3 costs $22,500. Here is the amount you will pay for the total cost of a 20% loan on your APR using a business loan calculator and the total cost of the loan.
| Loan amount | $75,000 | $75,000 | $75,000 |
|---|---|---|---|
| interest rate | 20% | 20% | 20% |
| Repayment period | 12 | 18 | twenty four |
| Interest paid | $8,371.06 | $12,430.32 | $16,612.44 |
| Total cost | $83,371.06 | $87,430.32 | $91,612.44 |
As you can see, loans with comparable APRs will have fewer loans than loans with coefficients. This means you will need to shop to see if you qualify for a comparable APR loan before accepting the loan with the coefficient.
When and why lenders use factor rates
Lenders often use factor rates when simplified lending options are required, and usually require quick financing times. Flat rates are simpler due to lender underwriting and repayment structures. This is commonly used by alternative lenders, such as short-term business finance options and those where repayments provide merchant cash advances related to future credit card sales.
When to take a loan at the factor rate
The main reasons for taking loans at factorial rates are as follows:
- Access is available to high-risk borrowers. Alternative types of funding, such as bad credit loans and merchant cash advances, tend to use factor rates. They are intended to help borrowers who do not qualify for traditional loans or require rapid financing.
- The cost is similar to APR loans. If you convert the coefficient rate into interest and find that the cost can be similar to that of an APR loan, you may get a loan at the coefficient rate. However, compare your factor rate loan with other loans to see if you can get better fees or repayment terms.
When factor rates may not be your best profit
- A short repayment timeline is required. The factor rate does not take into account the duration of the repayment, so paying off funds in the short term will result in higher borrowing costs.
- Your cash flow is inconsistent. Funding options such as Merchant Cash Advance typically deduct payments from daily or weekly credit card sales. If cash flow remains unpredictable, it may be too difficult to keep up with repayments.
Conclusion
Generally, business loans with coefficients cost more interest and fees than APR loans. However, the only way to get an idea of borrowing costs is to convert the factor rate into an annual interest rate.
Modified interest rates are not directly compared to APR, but they can closely compare the loan documents minus the interest charged. You can then decide whether you need to sign a coefficient loan or look for another option at a lower fee.
