Running a successful business requires regular cash flow and working capital. Every business goes through periods when sales are down and money is tight. When this happens, you may look to outside sources of funding. One of the various types of small business funding is a merchant cash advance.
What is a cash advance loan?
A cash advance allows you to borrow an immediate amount against your future income – the lender is "advancing" you the cash before you are paid. Technically, you are selling your future revenue in exchange for cash today, so a cash advance is different from a typical loan.
Personal cash advance loans are borrowed against your next payday, when the lender debits your checking account for the amount you borrowed – with additional fees. Lenders sometimes have borrowers write a check for the loan plus fees, then cash the check after the borrower receives the money.
The fees for these loans are often very high and can leave you saddled with significant debt. Cash advance loans are sometimes considered predatory. However, they can provide vital cash flow if you don't own a credit card.
There is a specific type of cash advance available – called a merchant cash advance loan – if your company needs immediate funding.
What is a merchant cash advance?
Merchant cash advance loans are a source of short-term funding if you cannot obtain financing from a bank or other source. These advances are borrowed against future credit card sales, and most of them are repaid – plus the associated fees – within six to 12 months.
To obtain a merchant cash advance, your business must have daily credit card transactions from your patrons and proof of at least four months of credit sales. Many merchant cash advance companies require that your monthly credit card sales be between $2,500 and $5,000 – depending on the amount of the advance. This allows the lender to confirm that you can repay the advance.
How do merchant cash advances work?
Merchant cash advance companies will most likely work with your business if you rely primarily on debit and credit card sales. This includes retail, service shops and the restaurant industries. However, these are two structures that would allow your company to get an advance if you don't have high debit or credit sales:
- Traditional merchant cash advance: Your businesses would gain an upfront sum with a traditional merchant cash advance. To repay the loan, a set percentage of daily or weekly sales is debited back to the cash advance firm until the advance – plus fees – is repaid. This is also known as a "holdback." The higher your company's sales, the faster the advance is repaid. However, do not encourage your customers to pay in cash to avoid a percentage of their sales going to repayment, as this is a breach of contract and could result in litigation.
- ACH merchant cash advance: With an ACH merchant cash advance, you would receive a sum upfront, then repay the advance through your company's checking account. A fixed daily or weekly sum is transferred from your business checking account through an automated clearing house (ACH) withdrawal until the advance – plus fees – is repaid. Unlike a traditional merchant cash advance, the debited amount remains the same regardless of your company's sales. These advances can be paid off more quickly than an advance that is debited against sales, unless your business runs out of available cash; in which case, you may be unable to make your daily or weekly payment.
How much you will pay in fees depends on how much risk the merchant cash advance firm is taking. Generally, the factor rate will be 1.2% to 1.5%. If you take out a $40,000 advance with a 1.5% factor rate, your total payment will be $60,000 (your $40,000 advance with $20,000 in fees).
A merchant cash advance is considerably more costly than traditional financing. It can also create a debt cycle that would force you to take out a second advance to pay back the first – resulting in additional fees.
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Merchant cash advance pros and cons
Taking out a merchant cash advance has these advantages and risks compared to other small business loans:
| Merchant cash advance pros | Merchant cash advance cons |
| Almost immediate access to cash | Extremely high APR, potentially as high as 200% |
| Easy repayment | High payment frequency that can hinder cash flow |
| Low credit scores acceptable | No impact on business credit score or report |
| No restrictions on loan use | Binding in ways that other loans aren't |
| No need to put up collateral | Unavailable to small businesses that don't accept credit card payments |
Is a merchant cash advance legal?
Merchant cash advances are legal because they are not considered loans. Instead, they involve the purchase and sale of future income. And, firms offering the financing don't have to follow regulations that traditional lenders are required to follow because the advance never lasts more than a year.
The fees paid with merchant cash advances are not technically considered an interest rate. If compared to one, however, the rate paid for a merchant cash advance is significantly higher than it would be for a bank loan. The equivalent annual percentage rate (APR) for a merchant cash advance fee can be up to 200% of the advance.
The APR equivalent is so much higher than traditional financing because a bank receives a monthly percentage on the balance your business owes, not the total amount of the loan. As the loan the balance reduces, the interest paid per month decreases.
However, a merchant cash advance fee is a fixed charge for providing the advance. The amount that you owe does not change, even as you pay back the advance.
Banks are regulated by federal and state laws intended to protect consumers against lending practices that are considered predatory. Merchant cash advance companies are not similarly regulated because they technically buy future receivables, they do not provide a loan. As a result, they are exempt from state usury laws that would otherwise prohibit charging fees higher than standard interest rates.
This lack of regulation means that if you work with a merchant cash advance company, you need to scrutinize your contract. These are some items you should look out for in the contract:
- Size of your advance: Some companies will advance more than a business can be reasonably expected to repay.
- Credit card processors: Most cash advance contracts prohibit switching credit card processors. Your contract may also require you to switch to a specific credit card processing firm before you can receive your advance.
- Billing practices: Some cash advance companies change billing practices without notifying the merchant borrowers. This can impact your ability to repay the advance.
- Holdback terms: The holdback is the daily or weekly amount repaid to the merchant cash advance company. If this amount is too high, your business may struggle with cash flow while you pay back your advance.
Why use a merchant cash advance?
Though the steep fees of merchant cash advances mean that many financial experts discourage them, these are good reasons to consider a cash advance for your organization:
- Funding access: You have almost instantaneous access to funding; advances are typically made within 24-48 hours.
- No collateral: If your business fails and the cash advance is not fully repaid, there is no legal liability. Consequently, your assets are not at risk as they would be with a bank loan.
- Auto repayments: There is no possibility of late charges from overlooked due dates because repayment is performed automatically.
- No minimum payments: With a traditional merchant cash advance, there is no minimum payment required. A month with slow sales means you pay less to the merchant cash advance company.
- Little paperwork: Applying for this type of loan requires minimal paperwork.
- Time: Merchant cash advances are available quickly if your company needs cash ASAP or you don't qualify for a traditional bank loan.
Merchant cash advances are a workaround to unavailable bank lending, particularly if your company has poor credit or is otherwise unable to obtain a traditional loan.
Do merchant cash advances hurt your credit score?
Merchant cash advances are typically available for your business if you have poor or no credit, but that doesn't mean the company will ignore your credit report. The providers will complete a background credit check as part of the application. Fortunately, this generally will not impact your business credit score.
Some providers may do a hard credit check before issuing you an advance. This type of check can potentially hurt your credit score. Ask what kind of credit check companies perform before you apply for the cash advance.
How do you apply for a merchant cash advance?
There are merchant cash advance companies that accept applications both online and in person, but the information they ask for on your application will be similar in either case.
A typical application is one or two pages. Here is what you will need to provide:
- Contact information for your business
- Your name and Social Security number
- The company's tax ID number
- Several months of your credit card processing history and bank statements
- Copy of the lease for where your business is located
- Proof of citizenship
- Blank check, or your checking account number and routing number
Applying for a merchant cash advance is quick, and you're approved in hours or days. Once approved, you will need to sign a contract agreeing to the advance amount, payback amount, holdback and repayment period. Once this agreement is signed, the advance is transferred to your bank account.
Alternatives to a merchant cash advance
If you need extra cash but are wary of a merchant cash advance, consider other financing solutions that provide working capital for your small business. There are a variety of small business loan types to choose from. Lines of credit, term loans and payment processor financing are just some of the options.
Business line of credit
A line of credit (LOC) is similar to a credit card. You can apply for and be approved for a set amount, which you can borrow against for the term of the LOC. You can never owe more than the upper limit of your line of credit, but you can repay the amount you owe and borrow again as many times as you need. You can open a line of credit for your company for any amount, often ranging from $2,000 to $500,000. Funding is generally approved in less than a week, and repayment terms are 3-12 months.
Fundbox is one lender that provides business lines of credit. Fundbox's fast, transparent application, pricing and approval processes can offer up to $150,000 over 3-6 months. Fundbox is known for its direct communication regarding how much you'll pay per week for its services and will automatically withdraw these fees from your bank account. Learn more in our full review of Fundbox.
Short-term loan
A short-term loan is an unsecured business loan offered by a private lender rather than a bank. These loans have lower interest rates and more transparency than a merchant cash advance, though lenders will review your credit history. Short-term loans generally offer up to $500,000 in one-time financing, are approved in less than a week and have repayment terms of three months to three years.
Fora Financial is a top lender for short-term small business loans. With Fora, your repayment period will be at most 15 months, and you can obtain loans of up to $500,000. You can set your payment schedule to fit whatever terms work for you, and you won't have to put up any collateral. Plus, the approval process only takes 24 hours, with funding of the loan as quick as 72 hours. You can learn more in our comprehensive review of Fora Financial.
Payment processor financing
If you use a credit card processing company like Square or PayPal, you may be eligible for financing these companies offer. You can apply for the loans, which are generally under $100,000, through your online account. They usually come with a factor rate of 1.1% to 1.16% – lower than a merchant cash advance.
Final thoughts on merchant cash advances
A merchant cash advance is a quick financing option for your business. However, the repayment terms can often be expensive. Before choosing an advance or any other form of business funding, understand the details of your contract and the long-term impact it can have on the financial well-being of your company.
Katharine Paljug contributed to the writing and research in this article.