The credit card processing company, Square, recently announced that they are launching their own merchant cash advance (MCA) program, called Square Capital.  And they have every reason to enter the space.  They are already serving a large population of independent merchants, and stand to make a huge profit by offering this type of finance product.  A recent article published on re/code comments on the potential high cost of Square Capital for merchants seeking financing.

MCA Terms and Pricing

Rather than pricing traditional loans based upon Annual Percentage Rate, or “APR,” the cost of MCA is quoted in what is known as a “buy rate.”  The buy rate is simply the total payback amount, divided by the amount advanced to the borrower.  For example, if the borrower receives $12,000 and has to pay back $15,000, the buy rate is 1.25.  Buy rates in the MCA industry typically range from 1.15 – 1.40.

MCA providers typically use the fixed payback amount and the flexible daily payment as a selling point.  While this may seem appealing to a business owner,  the financing costs more if you pay it back quickly. The author of the re-code article understands the basics of buy rate, but, like many who write on the topic of MCA, he vastly underestimates the cost of MCAs when translating “Buy Rate” to APR.

Square Capital Example

Using an example of a real offer received from Square Capital, let’s look at a $7,300 loan with an $8,322 payback. The payback is being made through a hold-back of 10% of daily credit card sales.  In this example, the buy rate is 1.14.  However, the term of the MCA depends on the amount of revenue the company generates, rather than being set over a specified period of time.

In trying to translate the cost of this MCA offer to an APR, most assume that, if the term is one year, the APR is 14%.  If the MCA is paid off in one month, rather than one year, the APR increases to what some estimate is at least 165%. This is a reasonable assumption…if you understand that the annual cost of this loan to be 14% of the amount advanced.

Why Amortization Matters

What many miss when converting “Buy Rate” into APR is that the actual cost of financing is much higher when a financing product is not an amortizing term loan.  A 12-month “fully amortizing” term loan of $7,300 at an APR of 14% would cost $7,865.35, compared to the Square Capital cost of $8,322.01, which is $456.65 less than the MCA product if paid back within one year.  The actual APR on the Square Capital MCA example is 26.71% if paid back in 12 months.

Now, let’s assume the Square Capital MCA is paid back within one month. The APR  in this instance increases a whopping 308.64%.   A one-month loan with a true 14% APR would only cost $85.17, a savings of $986.83 over the Square Capital product.

Even though there is no set payback timeline, Square has detailed knowledge of their merchants’ average revenues.  And because of this, it is likely that they offer a financing amount that gets them the pay-back period and yield they desire. This explains why most MCAs are 3-6 months.

Amortizing Loans Make a Big Difference

One of the simplest explanations for why MCAs are much more expensive than traditional loans is that they do not amortize. All interest is charged up front, and the borrower is required to pay back the same amount, no matter how quickly they pay the debt off.  It is impossible to save money by paying an MCA off early.

In contract, amortizing term loans accrue interest on the outstanding balance, so over the term of the loan, the borrower pays less and less interest. If the borrower pays the loan off early, they don’t pay interest that would have been accrued if the loan went to full term.

At Dealstruck, all of our term loans a true “fully amortizing” term loans. We charge our borrowers based on a simple APR,  and do not confuse cost by offering buy rates, hidden costs or fees.   If you are confused by an offer, let us know, and we are happy to walk you through your actual cost.