The Dangers of Merchant Cash Advances: Part 1
Posted September 23rd, 2022
Merchant cash advances, or MCAs, are loans that business owners usually look to in a crisis. Think of them as the equivalent to the business version of a paycheck advance loan with high interest and repayment terms that often do not align with what is best for the business. MCA’s are dangerous for most merchants but horrible for construction businesses, and we’ll explain why in this four-part blog series.
In our introduction to merchant cash advances, we will explain what a typical loan looks like and how the fees and costs are charged.
How MCAs Work
The basic requirements to qualify for an MCA are to submit an application that includes a business owner’s personal credit, social security number, business name, business address, and other simple information. Along with this application, they will submit four months of bank statements. Once the MCA lender gets those statements, they can evaluate the money this business receives through deposits. The MCA lenders may utilize different metrics, but they all end up with similar results. That result is that the loan or the advance amount they offer the business is close to the average amount of deposits the company has rolling through their account monthly.
For example, a business has an average of $200,000 in deposits. The lender will build out a repayment schedule for that $200,000, typically with a repayment period between six to twelve months. Before calculating the repayment period, the MCA lender needs to determine the “Factor Rate” they will charge for the loan. This Factor Rate will be the actual cost of the loan to the business. Factor Rates can vary depending on the company, business owner’s personal credit, industry, and other variables, but is typically between 35-50% for construction contractors.
So, with a quick math example, if an MCA lender gives a business $100,000, and the factor rate is 40, the company will repay them $140,000 over the loan term. If that term is 12 months, the interest or fees charged annually is 40%, but if the term is 6 months, the actual annual rate is 80%.
To determine the daily or weekly payment amount, the number of business days in the given period needs to be calculated (a typical month has 21 business days). If it’s a six-month term, they will take the $140,000 and divide it by the number of business days in that period.
6 months x 21 business days per month = 126 business days
$140,000 repayment / 126 business days = ~$1,111.11.
Now, $1,111.11 is the daily number that businesses will have deducted via ACH from their bank account.
Dangers of High-Interest Rates
These factors are a fixed fee or margin that businesses must pay back in addition to the amount they were advanced on the loan. One obvious issue is the loan is very costly in its short-term structure. Secondary to the cost, this loan is based on future receivables (the deposits they receive in their account), whether businesses receive that money or not. So, if companies don’t have enough future revenue to support the dollars they’re borrowing, it can be problematic when those loans need to be repaid—on a daily or weekly basis.
If you’re feeling stuck with payroll and vendor invoices, give us a call before resorting to a merchant cash advance. We’re here to help — (813) 712-3073