Small Business Loan vs. Cash Advance: What’s the Difference?

What are small business loans and cash advances?

Although both financing methods involve receiving and repaying money, merchant cash advances are not the same as loans. Rather, the business receives an advance against its future credit card sales, and the provider draws money from the business’s future credit card transactions as repayment. Payments are made daily or sometimes weekly.

The repayment amount is based on a percentage of daily credit card sales called the holdback, which may range from 10 percent to 20 percent. For example, if a business does $10,000 in credit card sales and the holdback is 10 percent, the repayment amount would be $1,000. The holdback percentage doesn’t change, but the payment amount may vary depending on the volume of credit card transactions.

The cost of an advance, called the factor rate, is also a preset figure. Also called the buy rate, it is usually expressed as a figure such as 1.2 or 1.4. An advance with a factor rate of 1.3 means the business will repay $13,000 for every $10,000 advance for a year.

Comparing costs

How merchant cash advances are priced can make it difficult to compare their costs with those of business loans. An advance charges all interest on the full amount upfront, while a loan charges interest on a smaller amount each month as the principal is paid off. Therefore, a $30,000 charge for a $10,000 advance is not equal to a 30 percent annual percentage rate (APR) business loan. Instead, it is closer to a 50 percent APR. With additional fees, the effective rate can go much higher.

Jared Hecht, partner at Magellan Ventures, which provides venture capital and private equity services, said users of advances often don’t realize the true cost. “We’ve seen customers who have taken out merchant cash advances and are paying an APR north of 150 percent and not even knowing it,” Hecht said.

Advances are short-term financing, so they are best suited for short-term needs, such as acquiring inventory. Most are designed to be repaid in six to 24 months. And unlike with most loans, paying off a merchant cash advance early will not produce any savings; the factor rate is the same regardless of how long it takes you to pay back the advance.

Because an advance does not require set monthly payments, a business will pay more when sales are good and less when sales are down. This can help businesses avoid cash crunches that might be more frequent with set monthly payments.

“For a business that is seasonal, that can be a lifesaver,” said Andrew Rafal, founder and CEO of Bayntree Wealth Advisors. “If they have a down month, they’re not going to have to cover the fixed cost of a small business loan.”

Overall, a business loan can be significantly less costly than a merchant cash advance. Hecht advised businesses to always check whether a business loan is available before taking an advance. For instance, he said, some merchant cash advance recipients could qualify for a Small Business Administration (SBA)-backed loan with a rate of 7 percent.

“A merchant cash advance can be tempting, but there are numerous pitfalls that can leave small business owners in poor financial shape,” Kiisel added.

Key differences

When you’re deciding between a small business loan and a merchant cash advance, make sure to consider the major differences listed below.

Speed of funding

Speed is an important benefit of advances. You can often apply for an advance online and have funds deposited into your business’s account in 24 hours. By comparison, it may take weeks for a lender to approve a borrower for a loan and to make the cash available.

Borrowing limits

A merchant cash advance can supply amounts from a few thousand dollars up to $250,000 or more. By comparison, most SBA-backed loans can go up to $5 million. SBA Express loans have a maximum of $500,000.

Borrower requirements

With an advance, credit score is not important; a business can be approved for an advance based on its history of credit card transactions. A bank business loan, however, typically requires the business owner to have a personal credit score of around 700 or higher.

The owner will often have to guarantee the loan personally and may have to provide additional collateral. For instance, a loan to buy factory equipment may be secured by the equipment or by a lien against the factory building.

The “right” option will vary based on your business’s needs

Merchant cash advances can be faster, involve less paperwork and be accessed by businesses with lower credit scores. However, they can cost considerably more than business loans, making loans preferable for borrowers who have the time and credit to obtain them.

“What we’ve found is that most customers can generally take the time to wait a week or two to understand their offers and get competitive offers from a broader array of lenders across a variety of product lines,” Hecht said. “That said, some customers don’t want to wait.”

Think a loan is right for you? Check out our guide to choosing the right loan for your business. 

Linda Pophal contributed to the writing and reporting in this article. Some source interviews were conducted for a previous version of this article.