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Grow Your Business Finances

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

Small Business Loan vs. Cash Advance: What's the Difference?
Credit: Love the wind/Shutterstock

If you're looking for cash to fund business growth, odds are you'll do it with a bank loan or a line of credit. But, especially for smaller businesses, merchant cash advances are another popular source of funds.

A 2015 Federal Reserve Bank of New York study found that, although loans and lines of credit are the most popular financing method among small businesses (57 and 52 percent, respectively), 7 percent had used merchant cash advances in the previous year. Smaller businesses were more likely to do this: 10 percent of microbusinesses (revenues below $100,000) took out merchant cash advances last year.

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

"Loan purpose should drive the whole conversation," said Ty Kiisel, head of financial education for OnDeck, an online provider of business loans. "That is going to tell you how much money you need and how much you can afford to spend for it."

Although both financing methods involve receiving and repaying a sum of money, merchant cash advances are not the same as loans. Rather, the business receives an advance against its future credit card sales, and the provider draws money from the business's future credit card transactions as repayment. Payments are made daily or sometimes weekly.

The repayment amount is based on a percentage of daily credit card sales called the holdback, which may range from 5 percent to 20 percent. For example, if a business does $10,000 in credit card sales, and the holdback is 10 percent, the repayment amount would be $1,000. The holdback percentage doesn't 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 figure. Also called the buy rate, it is usually expressed as a figure such as 1.2 or 1.4. An advance with a factor rate of 1.3 means the business will repay $13,000 for every $10,000 advanced for a period of a year.

The way merchant cash advances are priced 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 smaller amount each month as the principal is paid off. So a $30,000 charge for a $10,000 advance is not equal to a 30 percent annual percentage rate (APR) business loan. Instead it is closer to a 50 percent APR. With additional fees, the effective rate can go much higher.

Jared Hecht, co-founder and CEO of New York City-based Fundera, an online platform for matching businesses with loans and advances, says users of advances often don't realize the true cost.

"We've seen customers who have taken out merchant cash advances and are paying an APR north of 150 percent and not even knowing it," Hecht said.

Advances are short-term financing, and so are best suited for short-term for needs such as acquiring inventory. Most are designed to be repaid in six to 24 months. And unlike most loans, paying off a merchant cash advance early will not produce any savings. The factor rate is the same whether it takes the full intended term to pay back the advance or a shorter or longer time.

Because an advance does not require set monthly payments, a business will pay more when sales are good and less when sales are down. This can help to avoid cash crunches that might be more frequent with set monthly payments.

"For a business that is seasonal, that can be a lifesaver," said Andrew Rafal, president of Bayntree Wealth Advisors. "If they have a down month, they're not going to have to cover the fixed cost of a small business loan."

Overall, a business loan can be significantly less costly than a merchant cash advance. Hecht advised always checking to see if a business loan is available before taking an advance. For instance, he says some merchant cash advance users could quality for SBA-backed loans carrying a rate of 7 percent.

"A merchant cash advance can be tempting, but there are numerous pitfalls that can leave small business owners in poor financial shape," Kiisel added.

Speed of funding: Speed is an important benefit of advances. Advances can often be applied for online and funds deposited into the business's account in 24 hours. By comparison, weeks may pass from the time a bank loan is applied for until the borrower is approved and the cash is available.

Borrowing limits: A merchant cash advance can supply amounts from a few thousand dollars up to $250,000 or more. SBA-backed loans, on the other hand, can go up to $5 million.

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

The owner will often have to personally guarantee the loan and may have to provide additional collateral. For instance, a loan to buy factory equipment may be secured by the equipment, or by a lien against the factory building.

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

"What we've found is that most customers can generally take the time to wait a week or two to understand their offers and get competitive offers from a broader array of lenders across a variety of product lines," said Fundera's Hecht. "That said, 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.

Mark Henricks
Mark Henricks

Mark Henricks writes about business, personal finance, health, fitness and other topics from Austin, Texas. A graduate of the University of Texas School of Journalism, he has worked as a reporter, editor, author and freelance writer for many leading publishers. Reach him by email, on Twitter (@markhenricks) or visit his website, The Article Authority.