When your business is struggling, you may be tempted to find the quickest and easiest way to get working capital. But beware of financing options that sound too good to be true.
Merchant cash advances (MCAs) are one example of an option that business owners may turn to when they’re to get out of financial trouble. But are merchant cash advances a scam? Understanding what a merchant cash advance is, how it works, and how they’re repaid can help you understand why this route may be more harmful than helpful to your business.
What is a merchant cash advance?
A merchant cash advance is not technically a loan. A merchant cash advance company provides funding to a business owner in exchange for a portion of the business’s future sales. Traditionally, merchant cash advances were typically geared mostly towards retail businesses that mostly did credit and debit card sales. However, now merchant cash advances are available to most kinds of businesses.
How are merchant cash advances repaid?
Merchant cash advances can be repaid in one of two ways:
- A percentage of your credit and debit card sales: In this option, the servicer automatically withdraws a certain portion of your sales until the advance is repaid in full.
- Fixed daily or weekly withdrawals: In this option, the servicer takes a fixed amount from your business bank account on a daily or weekly basis, plus fees, until the balance is paid in full. These are known as Automated Clearing House withdrawals.
Because merchant cash advances are not technically a loan, they are not regulated the same way loans are. As a result, arguably the most important aspect to note is that merchant cash advances have factor rates rather than interest rates.
Like an interest rate, a factor rate is based on the risk assessment of the borrower. The higher your risk as a borrower, the higher your factor rate. Factor rates generally range from 1.2 to 1.5. But that’s not a percentage. Instead, you multiply the amount of the merchant cash advance by the factor rate. For example, if you take a $50,000 advance with a 1.4 factor rate, you will end up paying $70,000, including $20,000 in fees.
Why should you avoid merchant cash advances?
In determining whether merchant cash advances are a scam, it’s important to take a close look at the drawbacks of this financing option.
With traditional loans, the government is able to set a cap on interest rates. Merchant cash advances are not technically considered a loan, meaning they are not impacted by such regulations. The business’s sales, the fees charged, and the time it takes to repay determine the APR. As a result, APRs can actually rise into the triple digits. In contrast, traditional bank loans generally have an APR of around 10 percent.
Trapped in a debt cycle
Merchant cash advances may be considered a scam because of their ability to trap business owners in a debt cycle. Because of how expensive MCAs can be, business owners may need to take on more financing to pay off the original MCA. If you’re struggling to qualify for other funding options, you may end up taking out another MCA. This could put a major strain on your cash flow and make it difficult to keep up with your bills.
MCA companies also often use predatory lending tactics that are common for scammers. The companies will intentionally write contracts with obscure and confusing language. Additionally, MCA companies won’t disclose APRs, making it difficult to calculate the actual cost of the advance.
Confession of judgment
Many MCA contracts also require you to sign a confession of judgment. A confession of judgment means you have given up your rights to defend yourself if the company takes you to court.
What are some alternatives to merchant cash advances?
A merchant cash advance may not be the best option for your business. But you do have other routes you may be able to pursue to help you out of your jam:
Small business loans
If possible, traditional small business loans from a banking institution or the Small Business Administration are a favorable option for those that can qualify. Small business loans generally have much more manageable interest rates and repayment schedules than MCAs.
Loans from online lenders
If you’re struggling to qualify for traditional business financing options, some online lenders may be able to help. Online lenders may offer options specifically for business owners with a less-than-stellar credit scores. Some of these options may still be challenging for small business owners, with APRs creeping up to 99 percent. However, this may still be a better option than an MCA. They will be less costly. Additionally, many online providers report your payments to the credit bureau. As a result, you will build business credit. This can then help increase your chances of qualifying for future business funding options.
Turning to a financial professional, such as a debt attorney, can also be a great option. A debt attorney can help lead you in the right direction, which may include debt settlement. Debt settlement involves negotiating with your creditors to pay less than you owe.
The Bottom Line
Merchant cash advances can seem tempting because of the speed and ease in which your business can receive funding. However, the cost, predatory lending practices, and the potential to be trapped in a debt cycle with MCAs often do more harm than good for struggling businesses.
If your business is struggling with debt and you don’t know where to turn, Tayne Law Group, P.C. is here for you. Our team of debt professionals can help you get your business back on the road to financial freedom. Call us for a free consultation at 866-890-7337 or fill out our short contact form and we’ll get in touch!