Merchant cash advances can be dangerous but they can be a valuable method if used correctly. Running a profitable company requires daily cash flow and working capital.
Every company goes through periods of down-sales and tight capital. When this happens, a lot of business owners are looking for funding from outside sources. One form of financing is a cash advance for merchants.
We explain in this article what merchant cash advance loans are, their typical requirements, and what are their advantages and disadvantages.
What is a cash advance loan?
You can borrow an immediate amount against your future income with a cash advance–the lender “advances” you the cash before you are paid, hence the name.
Technically, today you sell your potential income in return for cash, so cash advances are different from a traditional loan.
Private cash advance loans are lent toward the next paycheck, as the bank account is debited by the lender for the sum you lent plus extra charges.
Lenders often make borrowers write a check for the balance of the loan plus fees, then cash the check after the date the borrower receives the money.
The payments on such loans are always very high, and lenders may be left saddled with considerable debt. Often, cash advance loans are considered predatory. They can also provide people with critical cash flow without credit cards.
There’s a different form of cash advance available for retailers and other companies in need of urgent financing called a merchant cash advance loan.
What does a Merchant cash advance mean?
Merchant cash advance loans are a means of short-term business funding for owners who cannot get finance from a bank or other means.
Such loans are lent against potential credit card transactions, and most of them are repaid within six to 12 months–plus the related fees.
To get a cash advance from the dealer, the company must have regular credit card purchases and proof of credit sales for at least four months.
Depending on the size of the advance, many retailer cash advance companies expect the monthly credit card transactions to be between $2,500 and $5,000. It helps the investor to ensure that the advance can be refunded.
How does Merchant cash advance run?
Traditionally, merchant cash advance firms have partnered with businesses that rely mainly on debit and credit card transactions, such as supermarkets, service stores, and restaurants.
Nevertheless, as to how such advances operate, there are two separate mechanisms that allow companies that do not have high debt or credit sales to get an advance.
Traditional cash advance for merchants: Companies earn an upfront amount. A fixed percentage of daily or weekly sales will be debited back to the merchant cash advance company (known as the “holdback”) before the advance is repaid, plus fees.
The higher the profits of the company, the quicker the advance shall be repaid. Encouraging the customers to pay in cash in order to stop a portion of their profits going to repay is considered a contract violation which may lead to lawsuits.
ACH merchant cash advance: Businesses get an initial amount, and repay it from their checking account by debits.
A fixed regular or weekly amount is transferred by an automated clearing house (ACH) withdrawal from the checking account before the advance, plus fees, is repaid.
Unlike a conventional cash advance for retailers, the debited sum stays the same, regardless of the selling volume for the company. Such loans can be paid out quicker than a debited advance on revenue, unless your company runs out of cash, in which case you will not be able to make your regular or weekly payment.
How much fees you’ll pay depends on how much risk the merchant cash advance company thinks it takes on. The factor rate would typically range from 1.2 to 1.5 per cent.
When you take a $40,000 advance with a factor rate of 1.5 per cent, the net payment would be $60,000: the advance of $40,000 plus $20,000 in fees.
A cash advance for the retailer is much more expensive than conventional funding.
This may also trigger a debt loop in which company owners are forced to take out a second advance to pay off the first one, resulting in extra costs.
Is Merchant Cash Advance legal?
Money advances from vendors are legal, as they are not considered loans. Alternatively, they include purchasing and selling potential sales.
If the advance rarely lasts more than a year, the lending firms do not have to comply with the rules that conventional lenders must follow.
The payments charged with retailer cash advances are not considered to be an interest rate in a legal sense.
Nevertheless, if the amount charged for a merchant cash advance is considerably higher than it would be for a bank loan compared with one.
The corresponding annual percentage rate (APR) can be up to 200 per cent of the advance with a retailer cash advance fee.
One reason the APR equivalent is so much higher than for conventional lending is that a creditor earns a percentage annually on the debt that the company owes, not the full amount of the loan.
The interest paid each month reduces as the debt is paid off and the balance reduced.
A cash advance fee for retailers, however, is a fixed payment for making the deposit. The balance you owe doesn’t change, except though you pay the advance back.
Banks are governed by federal and state laws designed to protect consumers from lending practices deemed predatory. Companies with merchant cash advances are not equally limited because they are actually buying potential receivables, not offering a loan.
As a result, they are exempted from state usury laws which otherwise would forbid charging fees that are so much higher than regular interest rates.
Does Merchant Cash Advance hurt your credit score?
Merchant cash advances are usually available to low-risk or no-payment companies, but that doesn’t mean the company would disregard your credit report.
In general, merchant cash advance providers can do a background credit check as part of the application. It won’t change your credit score in general.
Some providers can conduct a hard credit check before you issue an advance. This kind of search can potentially harm your credit score.
In order to deal with a cash advance company that does not affect your credit score, you will be able to find out what kind of credit check companies do before submitting.
Alternatives to a Merchant advance cash
If you need extra cash for your company but are wary of the drawbacks that come with a cash advance for the vendor, there are other funding options that provide small businesses with working capital.
Business line of credit: A credit line (LOC) is close to that of a credit card. You will apply for a fixed amount which you can borrow against for the duration of the LOC and be accepted.
You can never lend more than your credit line’s upper limit so you can repay as many times as you need the amount you owe and borrow again.
At any sum a corporation may open a line of credit, typically ranging from $2,000 to $500,000. Funding is usually accepted in less than a week, and terms of repayment vary from six months to 12 months.
Short-term loan: A short-term loan is an unsecured business loan given rather than a bank by a private lender. Such loans have lower interest rates and greater flexibility than a cash advance for retailers, while borrowers look at the credit background when considering a bid. Short-term loans typically provide up to $500,000 in one-time funding, are funded in less than a week, and have three to three-year repayment periods.
Financing for payment processors: If you use a credit card processing service such as Square or PayPal, you may be eligible for the financing they provide immediately. You can apply for these loans, which are usually under $100,000, through your online account. They typically come with a factor rate of 1.1 to 1.16 per cent, which is lower than a cash advance from a retailer.
A cash advance from a merchant is a fast financing choice for businesses with an urgent need for funding.
Nevertheless, the terms of repayment can also be costly and create further cash flow issues.
Comprehend the specifics of your contract and the long-term effect it will have on the financial well-being of your company before selecting an advance or some other form of company financing.