How Does a Merchant Cash Advance Work?
Because an MCA is a purchase of future revenue and not a loan, it isn’t regulated by the same laws that cap interest rates. Instead of an Annual Percentage Rate (APR), its cost is determined by a factor rate and its repayment speed by a holdback.
Let’s break down the key terms:
- Advance Amount: The lump sum of cash you receive upfront. For example, $20,000.
- Factor Rate: A multiplier, typically between 1.1 and 1.5, that determines your total repayment amount. If the factor rate is 1.4, your total payback is $28,000 ($20,000 x 1.4). The $8,000 difference is the MCA provider’s fee.
- Holdback (or Retrieval Rate): The percentage of your daily credit card sales the MCA provider automatically takes until the full $28,000 is repaid. A typical holdback is 10% to 20%.
On a day you make $2,000 in card sales, a provider with a 15% holdback would take $300. On a slower day with $500 in sales, they would take $75. This continues every business day until the debt is settled.
The High Cost of Convenience: Pros and Cons
MCAs offer speed but at a significant cost. Understanding the trade-offs is critical.
Pros:
- Fast Funding: Applications are simple, with funds often available in 24-48 hours.
- Accessible with Bad Credit: Eligibility is based on sales volume, not primarily your credit score.
- Payments Flex with Sales: The holdback model means you pay less on slow days, which can help manage cash flow compared to a fixed loan payment.
Cons:
- Extremely High Costs: When converted to an APR, MCAs can range from 40% to over 350%, making them one of the most expensive forms of financing.
- No Savings on Early Repayment: The payback amount is fixed. Unlike a loan, paying it off early doesn’t save you any money in interest. You owe the full, factored amount regardless.
- Cash Flow Strain: Daily deductions can drain working capital, making it difficult to pay for inventory, payroll, or other operational expenses, sometimes leading to a debt cycle.
- Lack of Regulation: As a sale of receivables, MCAs are not subject to federal lending laws, leaving businesses with fewer protections, a point highlighted by the Consumer Financial Protection Bureau (CFPB).
Real-World Example: A Pizzeria’s Emergency
Sarah’s Pizzeria needs $10,000 for a new dough mixer. An MCA provider offers her the cash with a factor rate of 1.35 and a 10% holdback.
- Total Repayment: $10,000 x 1.35 = $13,500. The cost of the financing is $3,500.
- Daily Repayment: If the pizzeria makes $1,200 in card sales, the MCA company deducts $120 ($1,200 x 10%).
- The True Cost: If Sarah pays back the $13,500 in six months, the $3,500 fee is equivalent to an APR of over 70%. This is far more expensive than most traditional business loans or credit cards.
Who Should Consider a Merchant Cash Advance?
MCAs are best reserved for short-term, high-return emergencies and are most common among businesses with a high volume of credit card sales, such as:
- Restaurants and bars needing to cover unexpected equipment failure.
- Retail stores that need to purchase high-margin inventory quickly.
- Auto repair shops with unpredictable but steady customer payments.
- Businesses with poor credit or limited operating history that cannot secure a traditional business line of credit or loan.
Frequently Asked Questions About Merchant Cash Advances
1. Is an MCA a loan?
No. Legally, it’s a commercial transaction—the sale of future receivables at a discount. This distinction allows MCA providers to bypass state usury laws that cap interest rates on loans.
2. Can I save money by paying off an MCA early?
No. The total repayment amount is fixed by the factor rate at the beginning of the agreement. There is no interest to save, so there is no financial benefit to early repayment.
3. Are the payments really flexible?
Yes and no. While a percentage-based holdback adjusts with your daily sales, some providers use a fixed daily or weekly ACH debit from your bank account. A fixed withdrawal can be dangerous, as it remains the same even on your slowest days, creating a high risk of overdrafts. Always clarify the repayment method.
4. What are the best alternatives to an MCA?
Before considering an MCA, explore less expensive options like SBA microloans, business credit cards, a business line of credit, or invoice factoring. These alternatives are more regulated and almost always offer lower financing costs.