What Is a Merchant Cash Advance?

One-quarter of small businesses get turned down for a loan.1 Merchant cash advances provide a tempting alternative—at a high cost.

Cash is tight for your business right now. You don’t have the time or the credit score to get a loan, but you have to make ends meet. Then you hear about a merchant cash advance and how it can give you money up front in exchange for a percentage of your credit card sales. Sounds perfect, right? Maybe—until you hear the details. Merchant cash advances, also called business cash advances, work like payday loans for businesses—with everything that implies. They provide a quick way to get cash without great credit, but the not-so-obvious costs can turn them into debt traps.

Cash is tight for your business right now. You don’t have the time or the credit score to get a loan, but you have to make ends meet. Then you hear about a merchant cash advance and how it can give you money up front in exchange for a percentage of your credit card sales. Sounds perfect, right?

Maybe—until you hear the details.

Merchant cash advances, also called business cash advances, work like payday loans for businesses—with everything that implies. They provide a quick way to get cash without great credit, but the not-so-obvious costs can turn them into debt traps.

Pros
  • Fast application and funding
  • Percentage-based repayment
  • High approval rates
Cons
  • High APR
  • Potential for debt cycle
  • Few industry regulations

Our guide below will cover these pros and cons in more detail so you have all the facts you need. Keep reading to find out everything you must know before you get an MCA.

What is a merchant cash advance and how does it work?

A merchant cash advance gives your business an up-front sum of cash in exchange for a fixed percentage of your daily revenue, called a retrieval rate. You pay this daily percentage until you repay the advance plus any fees. Your factor rate determines these fees.

Confused yet? Some people would argue that’s the point. But before we get to that, let’s break MCAs down further.

Factor rates and fees

As we said, you get the cash from a merchant cash advance in one up-front chunk. As part of the deal, you agree to repay your MCA provider the full cost of the advance, plus fees.

You’ll know from the beginning how much you owe in fees, thanks to your factor rate. This rate assesses your risk as a borrower and determines the fees you pay. It includes the cost of the advance and the costs of fees, and it usually falls somewhere from 1.2 to 1.5 times the cost of the advance.

Total amount formula

Amount you repay = Advance amount × factor rate

For example: $50,000 × 1.2 = $60,000

So if you get a $50,000 advance at a factor rate of 1.2, you’ll owe $10,000 in fees for a total of $60,000. Increase that factor rate to 1.5 and you’ll owe $25,000 in fees, bringing your total to $75,000. Take note: a factor rate increase of just 0.3 means an extra $15,000 in fees. The math matters here, so keep your calculator handy as you look at an MCA.

So how do you go about paying back your advance and fees, anyway? That’s where your retrieval rate comes in.

Retrieval rates and revenue

Like we described earlier, you pay back your advance by giving your MCA provider a fixed percentage of your business revenue. This percentage, known as a retrieval rate or holdback, depends on things like your projected revenue and your advance amount, but it usually ranges from 10% to 20% of your daily revenue.

Traditionally, merchant cash advance lenders get the retrieval rate as a percentage of your credit card and debit card sales. This transaction happens through your credit card processor, so your MCA provider automatically gets their cut without you having to do anything.

This process means that merchant cash advances have traditionally worked best for businesses that have lots of credit card sales each day, like restaurants or some retail stores. But in the words of Bob Dylan, the times they are a-changin’.

While you can still pay back your merchant cash advance through credit card sales, bank account withdrawals have become a common alternative. In this case, the merchant cash advance company makes a daily or weekly withdrawal from your bank account. You might see this called Automated Clearing House, or ACH, withdrawal.

Unlike the credit card sales method, the withdrawal amount won’t change depending on your actual daily revenue. The company will simply apply your retrieval rate to your anticipated revenue and withdraw that amount each time.

On the one hand, this method makes an MCA more accessible to businesses that don’t have tons of credit card sales. On the other hand, a slow week will make your cash crunch that much worse.

Terms

Unlike a term loan, repayment on a merchant line of credit doesn’t have a fixed term. Instead, you pay your retrieval rate until you’ve repaid your advance and factor rate fees.

For example, let’s assume you have to pay back $10,000, which includes all fees. The lender sets a retrieval rate of 10% of your daily revenue, which averages around $500. If we apply your retrieval rate to that revenue, you’ll pay about $50 a day. That means you’d end up with a term of 200 days, or a little under seven months, to repay your $10,000.

Usually, the merchant cash advance company will choose a retrieval rate so you repay your advance and factor rate between six months and one year. But again, your repayment depends on your daily revenue (unless you’re making ACH repayments), so the actual length will be unpredictable. If sales sag, you could keep making monthly payments for much longer than you expected.

In fact, we suggest you use the worst-case scenario for your planning. Don’t assume you’ll have six great months and pay off your MCA in no time—assume you’ll have low sales and a lengthy repayment term. That way, you can be pleasantly surprised if you do pay it off quickly, instead of unpleasantly shocked when you don’t.

Why get a merchant cash advance?

You may have noticed we’ve given you several warnings about getting an MCA. That might seem overdramatic, but there are plenty of reasons you should be wary of a merchant cash advance.

Merchant cash advance lenders have received lots of criticism for promising quick cash without clearly explaining the potential pitfalls. They’ve been accused of taking advantage of desperate business owners who don’t understand what they’re getting into.

In fact, many people, including Chicago Mayor Rahm Emanuel, have called for the federal government to start regulating the industry and have urged small-business owners to avoid MCAs altogether.

These people have a point. The merchant cash advance industry has far fewer regulations than the small-business loan industry, and many people don’t understand what they’re signing up for when they get an MCA: fast cash that comes with a high APR and a volatile repayment schedule.

That being said, we at Business.org don’t think you should write off merchant cash advances altogether. While you do need plenty of information before getting one (hence this article), we believe merchant cash advances can provide a way for business owners to get short-term working capital they can’t get elsewhere.

That’s one of the great benefits of MCAs, actually. Around 80% of people get approved for merchant cash advance financing, as compared to just 50% of people who apply for various types of SBA loans.2

Caution

Merchant cash advances are not a loan or form of credit, so they will not build your business or personal credit.

Even with bad credit, you can probably qualify for a merchant cash advance. In most cases, you just need to have been in business for six months with a history of credit card sales. Just gather your credit card statements, and maybe bank statements and your personal credit score, and you have everything you need to get approved.

Not only can you easily qualify for a merchant cash advance, but you can also get your money quickly. Unlike loans, which can have weeks-long application times and then take weeks more to process your business funding even if you meet all the loan requirements, MCA lenders usually have a turnaround of less than a week—often just one or two days.

Plus, many businesses find the percentage-based repayment helpful. Rather than struggling to a make a fixed loan payment during a slump month, they know they just have to pay a percentage of their revenue.

(Of course, you shouldn’t assume a retrieval rate will solve all your problems. If you usually make $5,000 per month but you unexpectedly make just $1,000 during a slow month, even a 10% retrieval rate will hurt you more than usual–you’ll probably feel the loss of $100 out of $1000 more than you’ll feel $500 out of $5000.)

Finally, you don’t have to offer collateral to get a merchant advance loan, since MCAs count as unsecured credit. One more warning, however: some merchant cash advance providers will ask for a personal guarantee, which makes you personally liable for the debt. Watch out for that.

When to get a merchant cash advance

Now that you know the potential pitfalls and benefits of an MCA, let’s set guidelines on when to get one. You should only get a merchant cash advance if you meet these criteria:

  1. You can’t get other forms of financing
  2. You have lots of credit card transactions
  3. You will use the money to grow your business

We’ve already covered the first two, so let’s talk about the third point.

Merchant cash advances should be used to develop your business rather than to save it. That is, you should use it for things like buying equipment or building inventory. These investments will bring additional revenue to your business, allowing you to repay your advance.

On the other hand, you should exercise caution when using an MCA for things like making payroll or paying bills. While important, these things won’t lead to a revenue increase, and getting an MCA adds another bill to pay. Your advance could smooth over unsteady cash flow, but it could also trap you in a debt cycle if don’t watch out. Borrow carefully so you don’t make your situation even worse than when you got the advance.

With those criteria in mind, here are a few more ways you might use merchant cash financing:

  • Taking advantage of a short-term sale to build inventory
  • Buying equipment that will quickly expand business opportunities
  • Purchasing new technology or software to increase efficiency
  • Adding more space or seating to improve your business’s capacity
  • Marketing events that will boost your sales

Whatever you use it for, do so with caution. In particular, make sure you understand all the rates, terms, and fees associated with your MCA.

Merchant cash advance rates and terms

We’ve talked a bit about factor rates, retrieval rates, and terms with an MCA, but let’s go a little deeper into the numbers.

As a reminder, factor rates usually range from 1.1 to 1.5, and retrieval rates fall between 10% and 20% of your daily revenue. Your term depends on your factor rate, retrieval rate, and actual revenue, but it often ranges from 6 to 12 months.

As far as the actual advance goes, typical advances fall between $2,500 and $250,000, though some companies advance as much as $2 million. Most MCA lenders use a formula of 250% of your monthly credit card sales to determine your maximum advance size.

With these numbers handy, we need to address the annual percentage rate, or APR.

All about APR

First, APR is a way to describe the total cost of a loan over the course of a year, including interest and other fees. It is not just another word for interest.

You can understand this best if we look at APR in terms of a loan’s length. Imagine two bank loans, both for $50,000. One has a higher interest rate, but because there are no fees, it has a lower APR. The other has a lower interest rate, but the fees mean it has a higher APR. Which should you get?

The answer depends on the term length. With a short-term loan, like five years, you’ll likely be better off with higher interest and low APR, because paying high fees over just a few years will cost you more than paying a little more interest. With a long term, like 10 years, you may be better served by the lower interest and higher APR, since those fees get spread over many years and you’ll accumulate less interest.

You can play around with an APR calculator to see this principle in action. But let’s get back to merchant cash advances.

Because MCAs don’t have interest, we can’t calculate a true APR for them. However, we can use a factor rate to calculate a faux APR, more politely called an “effective” APR.

Let’s look at how APR changes with your retrieval rate. For our purposes, assume we’re getting an advance of $10,000 with a 1.5 factor rate. That means we have to pay back $15,000 in total. Let’s imagine we have $15,000 in monthly credit card sales. How does our retrieval rate affect APR?

Retrieval rates and APR

Retrieval rateTime to repay Effective APR
10%10 months106.10%
15%7 months158.96%
20%5 months211.69%

A higher retrieval rate means we pay the advance back faster, but we have a higher APR.

Now, let’s look at sales instead. We still get a $10,000 advance with a 1.5 factor rate, but this time we have a 10% retrieval rate. Here’s how our monthly sales affect APR:

Monthly sales and APR

Monthly salesTime to repay Effective APR
$15,00010 months106.10%
$20,0008 months141.36%
$25,0006 months176.55%

The more you make each month, the higher your APR.

Remember, this is not showing you that you’re getting an awful interest rate—it’s showing that you’re paying tons in fees over a short period of time, giving you a sky-high APR.

So what should you get out of these complicated numbers? Two things:

  1. Merchant cash advances have much higher APRs than other forms of financing.
  2. Fast repayment might benefit the MCA company, but it effectively penalizes you.

Maybe you can see why some people think merchant cash advances are predatory or need further regulation. But for small-business owners who need fast cash, what alternatives exist?

Merchant cash advance alternatives

We recommend getting a business line of credit (LOC) over a merchant cash advance. Like a merchant cash advance, a business line of credit can help you quickly access the funds you need and improve your cash flow. But an LOC has a few advantages.

A business line of credit gives you revolving credit—you can repay it and then use it again—so you won’t have to reapply whenever you have cash flow issues like you would with a merchant cash advance.

Plus, the relatively low interest and fees on a line of credit make it a better deal APR-wise than a merchant cash advance. And an LOC actually builds your credit, so you can get approved for the best business loans in the future.

Merchant cash advance vs. business line of credit

Merchant cash advanceBusiness line of credit
Repay entire advance + feesRepay only what you use + interest
Get one up-front lump sumHave reusable, revolving credit
Fail to build your creditBuild your credit

Now, a business line of credit will have stricter application requirements than a merchant cash advance, so prepare for that. Still, 69% of applicants get approved for an LOC2—much higher than loan approval rates—so you still have good odds. And if you can’t get approved for a line of credit right now, you should make that a top financial goal for your business.

The takeaway

Merchant cash advance providers pitch MCAs as an easy way to get the money you need even with bad credit—but that’s only part of the truth.

With shockingly high APRs and the potential to worsen your money problems, merchant cash advances should be used only if you have no other options and can use it to grow your business. Otherwise, expect your merchant cash advance to create just as many problems as it solves.

Disclaimers

At Business.org, our research is meant to offer general product and service recommendations. We don’t guarantee that our suggestions will work best for each individual or business, so consider your unique needs when choosing products and services.

Sources

  1. Guidant Financial, “2018 Small Business Trends
  2. Federal Reserve Banks, “Small Business Credit Survey