How are merchant cash advances different from a business loan

Why is business financing important?

Financing can be essential for growing businesses. Small businesses may use financial services to launch new products and services, buy equipment, and hire additional staff. Financing may also help business owners prepare for emergency expenses and manage cash flow during seasonal changes.

Business loans and cash advances are two options for financing a business — but they have key differences that are important to understand.

What is a business loan?

A business loan is a type of financing in which a business receives money from a lender and pays back the money in regular installments over time, plus interest.

There are many types of business loans and lenders that could benefit small businesses. Business owners can apply for a business loan from a traditional bank or credit union, online lender, or lending marketplace. The U.S. Small Business Administration (SBA) also offers loan programs for growing businesses.

Each lender will typically set their own loan terms that will vary depending on the borrower's business and credit history.

Potential benefits of business loans

The potential benefits of business loans may include:

• Building credit history: Business owners may be able to build up their credit history and score by making on-time loan payments.
• Maintaining business control: Loans can be a way for businesses to access funds without giving up control or shares of their business.
• Predictable payments: By repaying loans in consistent installments over time, business owners can better plan for their financial future.

Potential cons of business loans

Some potential cons of business loans include:

• In-depth application process: Some lenders may require extensive documentation or collateral to apply for a business loan.
• Credit requirements: Business owners may need a strong credit history to qualify for a business loan, depending on the lender.

What is a merchant cash advance?

A merchant cash advance is not a loan, but rather a type of financing that business owners pay back with a percentage of their future sales.

Here's how it can work: A merchant cash advance company provides the business owner with a lump sum of money upfront. The business then repays the company from a percentage of the business's daily or weekly credit and debit card sales.

As with any form of financing, there are pros and cons to merchant cash advances.

Potential pros of merchant cash advances

The potential pros of merchant cash advances include:

• Flexible requirements: Business owners may not need a strong credit history or physical collateral for approval.
• Payments based on sales: Merchant cash advances typically don't have set payment amounts. Instead, they are generally repaid based on a fixed percentage of current sales. So, if sales are low, the payment amount may decrease accordingly.
• Quick access to funds: Since merchant cash advance requirements are flexible, business owners can often apply and receive funding quickly.

Potential cons of merchant cash advances

The cons of merchant cash advances include:

• Expensive fees: Merchant cash advances can come with high factor rates, origination fees, administrative fees, underwriting and/or funding fees compared to other types of business financing.
• Frequent payments: Merchant cash advances are usually repaid in daily or weekly payments instead of monthly installments.
• Lack of regulation: Merchant cash advances are not loans so they are not subject to state and federal lending laws and can pose potential risks for borrowers.

Merchant cash advances vs. business loans: How to choose.

It's important to understand the differences between a merchant cash advance and a business loan. Merchant cash advances, for example, may come with lower borrowing amounts and shorter repayment terms than business loans.

Costs for merchant cash advances and business loans are usually charged differently. Traditional loans typically come with fixed or floating interest rates, which are applied to the remaining loan balance each month. So if a borrower pays off their loan early, they may minimize the amount of interest paid on the loan.

Merchant cash advances, on the other hand, often charge a variety of fees and use factor rates, which are applied to the overall funding amount upfront. Factor rates can result in much higher financing costs than traditional loans. Also, repaying an advance early won't reduce the cost of the merchant cash advance because the factor rate is applied to the total payment at the start.

Ultimately, the choice of merchant cash advance vs. business loan will depend on the needs of your business.

Can business loans be paired with merchant cash advances?

Business loans can complement merchant cash advances. A business owner may use a business loan, for example, to expand their company with new equipment or office space. At the same time, they may use a merchant cash advance to access quick funding for a more immediate need, such as emergency expenses.

Learn more about how to apply for a small business loan.