Small Business Loan vs. Cash Advance: What’s the Difference?

If you’re looking for cash to finance the growth of your business, there’s a good chance you’re doing it with a bank loan or line of credit. But, especially for small businesses, cash advances from traders are another popular source of funds.

A 2015 study by the Federal Reserve Bank of New York found that while loans and lines of credit were the most popular financing method among small businesses (57 and 52%, respectively), 7% had used cash advances from traders during the previous year. Smaller businesses were more likely to do so: 10% of microenterprises (revenues less than $ 100,000) took cash advances to traders last year.

A loan or cash advance may be a good choice, depending on how the loan proceeds will be used.

“The purpose of the loan should drive the whole conversation,” said Ty Kiisel, head of financial education for OnDeck, an online provider of business loans. “This will tell you how much money you need and how much you can afford to spend on it.”

The mechanics of cash advances to traders

Although both modes of financing involve receiving and repaying a sum of money, cash advances from traders are not the same as loans. Instead, the business receives an advance on its future credit card sales, and the vendor withdraws money from the business’s future credit card transactions as a refund. Payments are made daily or sometimes weekly.

The refund amount is based on a percentage of daily credit card sales called withholding, which can range from 5% to 20%. For example, if a business makes $ 10,000 in credit card sales and the holdback is 10%, the refund amount would be $ 1,000. The percentage withholding does not change. However, the payment amount may vary depending on the volume of credit card transactions.

The cost of an advance, called the factor rate, is also a preset number. Also known as the buy rate, it is usually expressed as a number such as 1.2 or 1.4. An advance with a factor rate of 1.3 means that the business will repay $ 13,000 for every $ 10,000 advanced over a period of one year.

Compare costs

The pricing of cash advances to merchants can make it difficult to compare their cost with business loans. An advance charges all interest on the full amount up front, while a loan charges interest on a lower amount each month as the principal is paid off. So a charge of $ 30,000 for a $ 10,000 advance does not equal a 30% Annual Percentage Rate (APR) business loan. Instead, it’s closer to a 50 percent APR. With additional charges, the effective rate can go much higher.

Jared Hecht, co-founder and CEO of Fundera, a New York-based online platform for matching businesses with loans and advances, says advance users often don’t realize the real cost.

“We’ve seen clients who have taken cash advances from merchants and pay an APR north of 150% without even knowing it,” Hecht said.

Advances are short-term financing and are therefore better suited to short-term needs such as the acquisition of inventory. Most are designed to pay off in six to 24 months. And unlike most loans, prepaying a cash advance from a merchant will not produce any savings. The rate of the factor is the same, whether it is a question of repaying the advance over the entire duration provided for or over a longer or shorter period.

Because an advance does not require fixed monthly payments, a business will pay more when sales are good and less when sales are down. This can help avoid the cash crunch that might be more common with fixed monthly payments.

“For a seasonal business, this can be a lifeline,” said Andrew Rafal, president of Bayntree Wealth Advisors. “If they have a month down, they won’t have to cover the fixed cost of a small business loan.”

Overall, a business loan can be significantly less expensive than a cash advance from a merchant. Hecht advised to always check if a business loan is available before taking a cash advance. For example, he says that some merchant cash advance users could avail of loans guaranteed by the SBA with a rate of 7%.

“A cash advance from a merchant can be tempting, but there are many pitfalls that can leave small business owners in a bad financial position,” Kiisel added.

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Main differences

Speed ​​of financing: Speed ​​is a big advantage of advances. Advances can often be requested online and funds deposited into the company’s account within 24 hours. In comparison, it can take weeks from when a bank loan is requested until the borrower is approved and the money is available.

Borrowing limits: A merchant cash advance can provide amounts of a few thousand dollars up to $ 250,000 or more. In contrast, loans guaranteed by the SBA can reach up to $ 5 million.

Borrower Requirements: Credit history is not important with an advance. A business may be approved for an advance based on its credit card transaction history. A bank business loan, however, will generally require the business owner to have a personal credit score of around 700.

The owner will often need to personally guarantee the loan and may need to provide additional collateral. For example, a loan to purchase factory equipment may be secured by the equipment or by a lien on the factory building.

The bottom line

Merchant cash advances can be faster, involve less paperwork, and be accessible to businesses with less credit history. However, they can cost considerably more than commercial loans, making the loans preferable for borrowers who have the time and the credit to obtain them.

“What we have found is that most clients can usually take the time to wait a week or two to understand their offers and get competitive offers from a wider range of lenders on a variety of product lines. products, ”said Hecht of Fundera. “Having said that, some customers don’t want to wait.”

Think a loan is right for you? Check out Business News Daily’s guide to choosing the best loan for your business.

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