A merchant cash advance, or MCA, isn’t necessarily a traditional loan but rather a cash advance that you repay from daily credit card sales.
If you’re a small business owner who needs capital now, a merchant cash advance loan can seem appealing. However, this quick access to cash can be detrimental to your business in the long run.
This hazard occurs because MCAs are known to carry annual percentage rates in the triple digits. As such, the total cost of the loan can cause severe cash flow issues.
For this reason, MCAs can lead to a debt trap where it becomes impossible to repay, and you continue refinancing MCAs until you file for bankruptcy. MCAs are seen as a last resort option and usually not recommended unless you’re dealing with specific circumstances.
In this in-depth guide, you’ll learn exactly what merchant cash advances are and how to make a wise financing choice for your business.
What Is a Merchant Cash Advance?
Merchant cash advances are an alternative financing option to a traditional small business loan. MCA providers state that merchant cash advances aren’t technically loans. Instead, an MCA provider offers an upfront sum of cash in exchange for a piece of your future sales.
How Does a Merchant Cash Advance Work?
Typically, merchant cash advances are used by businesses that primarily earn revenue through debit and credit card sales. These businesses include restaurants or retail shops.
However, MCAs are now more available for all businesses that rely heavily on debit or credit card sales. As such, MCA repayments can be structured in two different ways.
The first method involves you receiving an upfront sum of cash in exchange for a portion of your future debit and credit card sales. The second method involves receiving upfront cash that is repaid through fixed daily or weekly debits from your bank account. These are known as ACH, or Automated Clearing House, withdrawals.
The second method is the most common type of MCA because it allows businesses that don’t rely on debit and credit card sales to take advantage of MCAs.
Rather than making a fixed payment every month, merchant cash advances allow you to make daily or weekly payments, including fees, until you repay the advance in full.
The amount you pay in fees is determined by your ability to repay the MCA. The MCA provider will determine a rate based on their risk assessment that usually ranges from 1.2 to 1.5. For example, an advance of $100,000 with a factor rate of 1.5 represents a total repayment of $150,000, which includes fees of $50,000.
Why Do Lenders Offer Merchant Cash Advance Loans?
Lenders offer merchant cash advances loans because of the high repayment terms. By providing upfront cash, lenders can charge above-average interest rates.
As such, lenders can generate high returns through merchant cash advance loans.
Terms and Repayment Structures for a Merchant Cash Advance
Here’s a more extensive breakdown of how merchant cash advance repayments are structured:
Percentage of Credit Card Sales
The lender will automatically deduct a percentage of your debit or credit card sales until the agreed-upon amount is fully repaid.
For example, let’s say you need $100,000 to purchase inventory for your business. In this example, you are accepted for an MCA and receive a factor rate of 1.5. As such, you need to repay $150,000 total.
The repayment period of an MCA generally ranges from 3 to 12 months. As such, the higher your debit or credit card sales, the faster you can pay back the merchant cash advance.
Daily Fixed Withdrawals
With daily fixed withdrawals, this agreement lists a daily or weekly payment to be withdrawn from your bank account.
Unlike the repayment structure tied to your debit or credit card sales, your payment doesn’t fluctuate with your sales when using a daily fixed withdrawals structure.
For example, a business with $50,000 monthly revenue would owe $166 per day or $1,166 per week regardless of if sales are up or down.
Is a Merchant Cash Advance a Good Idea for Your Business?
When determining if a merchant cash advance loan is right for you, there are both positive and negative effects to consider.
- Fast access to cash
- Flexible repayment terms
- Strong credit not required
- You choose how to spend the cash
- No collateral required
- Extremely expensive (70% to 200% APR)
- Minimum daily or weekly payments impact your cash flow
- Doesn’t help your business build credit
- May lock-in merchant processor
As you can see, there are many factors to think about.
Why Get a Merchant Cash Advance
Businesses opt for merchant cash advances primarily for fast access to cash. This approach makes sense, as most providers can get you the cash within 48 to 72 hours. Furthermore, providers don’t require excellent personal or business credit.
Another reason why MCAs can be a choice is that the issuer doesn’t restrict how you spend the cash. You have complete freedom over what you want to use the funds for.
Lastly, you don’t need to put up any collateral for a merchant cash advance loan, and providers also offer flexible repayment terms. As such, merchant cash advances are ideally used for:
- Temporary cash flow aide
- Purchasing inventory at discounts
- Unexpected expenses
- Paying off other debts
- Working capital
While expensive, they do have their place.
Reasons to Be Cautious
The main reason to be wary of merchant cash advance loans is that they can be very expensive. If you’re given a high factor rate, you can pay up to 200% APR. Even a low factor rate can mean you have to pay around 35% APR.
Furthermore, since MCAs aren’t technically loans, providers won’t report your payment history to business credit bureaus. This lack of reporting means you won’t build credit with a merchant cash advance loan.
It can also be difficult for businesses to manage their cash flow when faced with fixed daily or weekly payments.
Other Frequently Asked Questions
Let’s look at the answers to some popular questions:
What Happens If You Default on a Merchant Cash Advance?
Defaulting on a merchant cash advance should be avoided as much as possible. If you do default on a merchant cash advance, the provider will pursue your personal and business assets to recoup their advance.
How to Get Out of a Merchant Cash Advance?
If you opt for a merchant cash advance and realize it’s too challenging to make the repayments, you’ll need to refinance the MCA with a lower-interest loan.
The most cost-effective way of refinancing an MCA is with a conventional small business loan. The interest rates on these loans are usually lower than MCAs and often offer more favorable terms.
However, you’ll need a personal credit score above 650 and a good business credit history to be accepted for most small business loans.
Another way to get out of a merchant cash advance is to refinance it using an asset-based loan. Although asset-based loans are more expensive than small business loans, they allow you to capitalize on assets such as accounts receivable, inventory, or real estate.
Alternatives to a Merchant Cash Advance
If a merchant cash advance doesn’t seem ideal for your business, other financing options include:
- Online small business loan
- Short-term loan
- Business cash advance
- Accounts receivable financing
As you can see, you always have options.