For new business owners and small businesses with poor or no credit histories, merchant cash advances can be an easy way to gain access to capital. But in most cases, merchant cash advances can do more harm than good to your business.

If you’re considering a merchant cash advance, here’s what you need to know about how they work, why you should avoid them, and what you should use instead to get funding and grow your business.

What Is a Merchant Cash Advance?

A merchant cash advance (MCA) is a form of alternative business financing. It’s not technically a loan, but an advance on your future credit and debit card sales. In some cases, you can even get an MCA that’s not tied directly to your sales.

If you get approved for a merchant cash advance, you’ll receive a lump-sum payment, then you’ll pay it back with a percentage of your debit and credit card sales or regular payments from your business bank account.

Merchant cash advances can be appealing to small business owners who have relatively stable sales but are struggling to obtain capital for short-term needs. 

However, MCAs can be incredibly expensive, and their terms often contain predatory practices that can threaten your small business and your livelihood.

How Merchant Cash Advances Work

A merchant cash advance can work in a couple of different ways, based on either your credit and debit card sales or your bank statements. Here’s a breakdown of how each type works.

Merchant Cash Advances

This is the traditional form of merchant cash advances, and it’s predominantly tied to debit and credit card sales. 

If your small business revenues come primarily from credit and debit cards, you could get an advance on future sales in the form of a lump sum, similar to an installment loan.

But unlike an installment loan, these traditional merchant cash advance agreements collect payments by taking a percentage of your sales. 

The MCA provider will partner with your payment processor to assess your sales and collect payments on a daily basis. 

Instead of charging interest, the cost is based on a factor rate, which typically ranges from 1.1 to 1.5. This means that if you receive an advance of $10,000, you’ll ultimately pay back between $11,000 and $15,000.

MCA providers determine your factor rate based on your revenue, creditworthiness, and other factors. 

ACH Merchant Cash Advances

While MCAs have traditionally been based on ongoing sales, it’s now also possible for small businesses without strong credit and debit card sales to get a merchant cash advance.

Instead of looking at your sales, these MCA providers will review your bank statements to determine your cash flow situation and how much you can afford.

Then, in exchange for giving you the advance, the provider will take daily payments from your business bank account to satisfy the loan. Instead of it being a percentage of sales, though, your payment will be a fixed amount.

As with traditional MCAs, ACH merchant cash advances charge a factor rate instead of interest. 

Typical MCA Financing Costs

The factor rate on a typical merchant cash advance is between 1.1 and 1.5. But because MCAs are a form of short-term financing, that translates to an APR range that goes from 40% to 350%. 

In other words, merchant cash advances are one of the most expensive types of financing for your small business, and if you’re not careful, they can cause more cash flow problems than they solve.

To get an idea of how much an MCA will cost you, it’s a good idea to use an online merchant cash advance calculator.

To give you an example, let’s say you receive an advance of $20,000 with a factor rate of 1.3. (We’ll use an MCA calculator to help us figure out the payments.) 

Your monthly debit and credit card sales average about $20,000, and your MCA provider requires a 15% holdback rate or the percentage of your daily sales that it takes to satisfy the debt.

With this arrangement, you’ll pay back a total of $26,000 with daily payments of $100 on average. It’ll take 260 days to repay the debt in full, and your APR will be 76.95%. 

Take that same advance and increase the factor rate to 1.5, and your effective APR will be 106.15%, with $30,000 in total payments over 300 days.

MCA Advantages

Merchant cash advances exist because small business owners use them. Here are some of the reasons why it might be appealing to take advantage of this form of short-term financing for your business:

• They’re easy to obtain: You don’t need great credit to get approved for an MCA, and you don’t need to meet high revenue or time-in-business targets like many types of business loans. As long as you meet the sales or bank account cash flow requirements, you can get approved.
• They don’t require collateral: Unlike many business financing options, you don’t need to provide collateral to secure a merchant cash advance. Instead, you allow the MCA provider to gain direct access to your payment processing or business bank account to collect payments.
• Payments tied to sales may not be oppressive: While MCAs charge high APRs, the daily payments tied to debit and credit card sales will go down if your sales go down. This approach to making payments as a percentage of your sales can come in handy compared to a term loan with a fixed monthly payment.
• They’re fast: If you meet all the eligibility criteria, you can typically get access to your MCA funds within a week. In contrast, some small business loans take weeks or even months to fund. If your capital needs are urgent, this can be a better option.

Why MCAs Are Usually a Bad Idea

Despite their benefits, merchant cash advances are not a good idea in most cases because the cons generally outweigh the pros. Here are some reasons to think twice about getting an MCA for your small business:

• They’re expensive: APRs can climb into the triple digits with merchant cash advances, making them one of the most expensive ways to obtain capital for your business. Even online business loans, which don’t have as stringent standards as traditional business loans, don’t charge that much.
• There’s no benefit to repaying early: The factor rate on a merchant cash advance is fixed, which means you’ll pay the same amount whether or not you pay down the debt early. With traditional business loans that charge interest, you can often save money by paying it down more quickly.
• The higher the sales, the more expensive in terms of APR: If your MCA is based on your credit and debit card sales, increasing sales will result in a faster repayment, but since the factor rate is fixed, you’ll only end up with a higher annual percentage rate on the debt.
• No federal regulations: Merchant cash advances are structured as commercial transactions, not loans, which means they’re not subject to federal oversight. They’re also not subject to the Truth in Lending Act, which provides several protections for borrowers. Instead, they’re subject to the Uniform Commercial Code (UCC).
• Contracts are confusing and potentially dangerous for your business: MCA contracts can be difficult to understand and can contain terms that are unfamiliar to you. Additionally, most merchant cash advance agreements include a clause called a confession of judgment. If you sign it, you’re essentially giving away your right to defend yourself if the MCA provider decides to sue you. In fact, they can sue you and obtain a judgment without notifying you in advance. Avoid these contracts if you can.
• They can compound cash flow problems: If you’re considering an MCA because of issues with your cash flow, getting an expensive form of financing that requires daily repayment may not be the best solution. Many small business owners find themselves needing another advance to help them satisfy the terms of their current one, and it could end up putting you through a vicious cycle of debt.
• They won’t help you build business credit: MCA providers typically don’t report your payments to the commercial credit bureaus, so if you’re looking to use one to build your business credit history, you’ll want to look elsewhere.

What to Get Instead of an MCA

If you need access to capital, there are plenty of better alternatives to a merchant cash advance, even if your business is new or your business credit history is in less-than-stellar shape. Here are some options to consider.

Business Credit Cards

A business credit card can be a good way to get access to a credit line for working capital purposes. These cards don’t typically have the same time-in-business and revenue requirements as traditional business loans, and you can even get one if you’re just starting out.

Additionally, small business credit cards can provide other benefits, such as rewards, insurance protections, and expense management tools to help you get value back every time you use them.

Just keep in mind that although most business credit cards don’t require a security deposit, you’ll likely need to provide a personal guarantee, which means you’ll pay off the debt if your business can’t afford to.

Also, in some cases, business credit cards can impact your personal credit, but if you use them responsibly, you won’t need to worry about negative consequences.

Online Business Loans

Several online lenders can offer fast funding and less stringent creditworthiness requirements than traditional business loans from big banks and credit unions. 

You’ll likely still need to meet certain requirements related to your time in business, revenues, credit history, and other factors. Also, you may be required to put up collateral to secure the loan. 

But if you’re looking for a short or medium-term business loan or a business line of credit, you can save money by going through an online lender instead of obtaining a merchant cash advance.

Equipment Financing

If you need money to buy some equipment or machinery for your small business, an equipment loan could be a good fit. These loans require you to use the equipment you’re buying as collateral, and you may need a large down payment.

But if you can make that happen, equipment financing typically carries low-interest rates compared to other types of business financing. You’ll also get a much longer repayment period, which can relieve a lot of pressure for you and your cash flow.

Get Money From Family and Friends

If you’re just starting out, one way to get help building your business from scratch is to request help from loved ones. This can be challenging if you don’t have a strong relationship, and you’ll want to draw up a contract to make sure that you repay the debt in a timely manner.

But these types of loans can be cheap or even free in terms of interest, and they can help you build your business without the pressure of daily payments from your sales or bank account.

Build Your Business Credit

Your business credit scores can impact your ability to obtain inexpensive financing for your small business, and while it may not help in a situation where you need capital urgently, taking the time to build business credit can open up much better opportunities in the long run.

One way to do this is to use other forms of financing discussed above since MCAs don’t report to the commercial credit bureaus. Another is to use a business credit builder account from Credit Strong. 

When you apply for a business credit builder account, the loan funds will be locked in a separate account as you make your monthly payments (over 5 or 10 years). 

As you make your monthly payments, Credit Strong reports them to the commercial credit bureaus, helping you establish your business credit history. Then once you’ve paid in full, you’ll receive the loan funds to use however you wish.

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