A Comprehensive Guide to Merchant Cash Advances

Nowadays, merchant cash advances are ubiquitous with merchant account services. However, not many business owners understand what it is, how it is paid out and repaid, or any risks to be aware of. Merchants seldom understand the differences between merchant cash advances and other types of funding, or if their business needs that type of funding. Below we lay out a comprehensive guide to Merchant Cash Advances so that business owners can make an informed decision about their funding needs.

Merchant cash advances – What is it?

A merchant cash advance is an early payment in exchange for future credit or debit card receipts that the merchant is likely to process. Since this product is not technically a loan, it is not subject to regulatory oversight, which protects consumers from predatory lending practices such as excessive interest rates. Merchant cash advance (MCA) providers don’t charge an APR on the product but a fee, also known as a factor rate. So if a business receives a merchant cash advance of $10,000 at a factor rate of 20%, the payback will be the principal plus a factor fee of 20%, so $12,000.

The MCA providers also don’t assess the creditworthiness and the risk profile of a merchant as a traditional lender would. Those factors are judged based on the volume of past payments processed within a particular duration.

How exactly do merchant cash advances work?

As we mentioned earlier, MCA carries a factor fee that, along with a merchant’s credit limit, is predicated on the merchant’s risk profile using past payment processing trends. Once that information is considered, the advance is processed relatively quickly, often within 24 hours.

Once a merchant receives the MCA, the repayment process starts immediately, usually daily, but they’re still a few MCA providers who collect it weekly. The repayment mechanism happens in one of two common ways.

The first option for repayment is split processing, where the MCA provider partners with a merchant’s payment processor to recoup a specific portion of the payments processed. This is the preferred option by merchant account providers that also offer MCA funding.

The second option is daily or weekly Automated Clearing House (ACH) withdrawals. Payments are directly debited from the business’s bank account in either a predetermined fixed amount or a variable amount based on a percentage of sales. ACH also happens to be the more common of the two options as the product can then be offered to businesses that aren’t solely  reliant on payment processing.

Wait, so how are merchant cash advances not a loan?

So we’ve established that the MCA providers don’t assess creditworthiness as traditional lenders do. The factor rate they charge is much higher than an APR available from a bank. These are all connected to the fact there isn’t regulatory oversight of the MCA product as there is with loan products. However, there are other apparent reasons MCA are not loans.

MCA doesn’t have a fixed term. Traditional loans must be repaid in a certain period; a car loan within three years or a mortgage within 30 years. However, MCA doesn’t have a term length. Repayments can vary by sales, but there is no hard and fast rule for the duration.

Also, MCA often doesn’t have fixed payments. Where loans have a set amount that includes principal and interest, MCA is often determined by daily sales, of which a certain percentage goes towards repayments. This usually can work well for merchants; when sales are slow, payments can be too.

What are the risks of merchant cash advances?

The most common risk for using merchant cash advances is the rate you pay for the advance. Let’s say that a merchant took an MCA of $10,000 at a factor rate of 30%. If the MCA is repaid within a year, that’s an annualized rate of 30%, equal to some credit card rates. However, if the repayment is contingent on credit or debit card payment at a pace that it is repaid within six months, the annualized rate is 60%. So effectively, there is no benefit of repaying the MCA early.

Another risk is that the merchant may be asked to change their payment processor. If the MCA provider does not have a relationship with your merchant account provider or cannot establish one, the MCA provider may require you to switch payment processors. The MCA relies on the merchant account provider for split processing, where the payment processor deducts a portion of the payments processed and transfers it to the MCA provider, after which the remainder is transferred to the merchant.

Finally, there is a considerable lack of supervision of MCA providers, which are not technically considered lenders. Thereby not subject to a myriad of regulatory bodies that traditional lenders are, such as the FDIC, The Federal Reserve, the OCC, the CFPB, the Treasury Department, and individual state-level divisions of finance and treasury. At most, MCA providers are answerable to their domiciled state’s Uniform Commercial Code.

Does my business need merchant cash advances?

Regardless of the reputation and risks posed by MCA, they still have their advantages for the product to be a viable option for some merchants. First, the MCA can be processed as quickly as 24 hours in many situations. There are specific data points needed that, once provided, can soon help the MCA provider determine the credit amount they can offer and at what factor rate.

Other than speed, MCA doesn’t require prior credit or collateral to be processed. The advances are offered based on future cash flows, and the MCA provider has sufficient recourse built into the transaction to guarantee repayment of the advance.

As a small business starts or is in a growing phase, there can be a tremendous need for funding, which is hard to gain as a new business due to a lack of established credit history or simply poor credit. Regardless, merchants still have many options, including merchant cash advances. It is essential to consider all the different funding options available, weigh the pros and cons, and make an informed decision.

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