Understanding pricing models in commercial financing
What are the common pricing models in commercial lending?
In commercial lending, various pricing models are used, including:
Interest rates: This is the cost of borrowing money, often expressed as a percentage of the loan amount. For example, a 10% interest rate on a $100,000 loan means you'll pay $10,000 in interest.
Fees: These are additional charges that can include origination fees (e.g., 2% of the loan amount), application fees, and late payment fees.
Factor rates: Common in short-term loans or merchant cash advances, these are represented as a decimal figure (e.g., 1.2) rather than a percentage. For a $50,000 loan with a factor rate of 1.2, the total repayment will be $60,000.
Merchant cash advances: This is an advance on future credit card sales, repaid through a percentage of daily sales. If you receive a $30,000 advance with a 10% cut of daily sales, and you make $1,000 in daily sales, $100 goes to the lender each day.
Revenue-based financing: Here, repayments are a percentage of monthly revenue, fluctuating with your business income. If the agreement takes 5% of monthly revenue and your business earns $100,000 in a month, you pay $5,000.
How do interest rates work in commercial loans?
Interest rates can be either fixed or variable. A fixed rate remains constant throughout the loan term, like a 5% fixed rate for a five-year loan. Variable rates fluctuate based on market conditions, which could lead to payments varying over time.
What are factor rates, and how are they different from interest rates?
Factor rates are used in short-term business loans and MCAs. Unlike interest rates that compound, factor rates are a one-time charge. For example, a $20,000 loan with a factor rate of 1.3 results in a total repayment of $26,000, regardless of the repayment time frame.
What is a merchant cash advance?
A merchant cash advance provides funds in exchange for a portion of your future credit card sales. It's typically repaid through daily or weekly deductions. For instance, if you receive a $40,000 advance at a 12% holdback rate and your daily credit card sales are $2,000, the lender takes $240 daily.
How does revenue-based financing work?
In revenue-based financing, repayments change with your monthly revenue. This is particularly useful for businesses with seasonal sales patterns. For instance, if you borrow $50,000 and agree to repay 6% of monthly revenue, your repayment amount adjusts with your income.
What is APR, and how does it differ from other interest rate models?
APR (annual percentage rate) provides a more comprehensive yearly cost of the loan by including interest and other fees. For example, a loan with a 10% interest rate and 3% in additional fees has an APR of approximately 13%.
What should SMBs consider when choosing a financing solution?
SMBs should consider:
Total cost of borrowing: Understand all the fees, like a loan of $100,000 with a 5% fee adds $5,000 to your cost.
Repayment terms: Ensure they align with your cash flow. A short-term loan might require quicker repayments than your business can handle.
Loan purpose: Match the financing type with your need, like using equipment financing for purchasing machinery.
Flexibility: Some loans offer more flexibility in repayments which can be helpful for fluctuating incomes.
Credit impact: Understand how the loan affects your business credit score.
Final thought
Understanding these concepts is vital for SMB owners to make informed decisions about commercial financing. Always read the fine print and consider consulting a financial advisor to find the best solution for your business's unique needs.