Factor rates and interest rates both describe the cost of capital. They do so in languages that are mutually unintelligible, and the confusion between them has transferred billions of dollars from small business owners to MCA funders who understood perfectly well what the difference meant. The two pricing structures share nothing except the word “rate,” and that shared word is the source of more misunderstanding than any other term in commercial finance.

Fixed Total Versus Accruing Balance

An interest rate is a function of time. A factor rate is not. This is the core distinction, and everything else flows from it.

A business loan at 12 percent annual interest accrues cost as the months pass. Each payment reduces the principal, and each subsequent month’s interest is calculated on the remaining balance. The total cost of the loan cannot be known with precision at origination because it depends on the repayment schedule. The borrower who pays early pays less.

A factor rate of 1.2 produces a total repayment obligation the moment the advance is funded. On a hundred thousand dollar advance, the merchant owes one hundred twenty thousand dollars. That figure does not change. It does not decrease with early payment. It does not increase with slow payment. It exists as a fixed fact from the first day, indifferent to the merchant’s behavior, revenue, or circumstances.

The interest rate model assumes that time has value and that early repayment deserves compensation. The factor rate model assumes neither.

Annualized Cost and the Compression Effect

Because a factor rate is not annualized, comparing it to an interest rate requires conversion. And the conversion produces numbers that the MCA industry would prefer not to discuss.

A factor rate of 1.3 on a twelve month advance implies an annualized cost of roughly 30 percent. That same factor rate on a six month advance implies roughly 60 percent. On a four month advance, the figure approaches 90 percent. The factor rate did not change. The time changed. And because MCA holdback percentages often produce repayment periods far shorter than a year, the effective annual cost of most merchant cash advances sits between 40 and 350 percent.

The factor rate’s apparent simplicity is a feature, not a deficiency. A number that appears low encourages signing. A number that changes with time might prompt additional questions. The MCA industry chose the metric that minimizes questions.

Amortization Exists Only on One Side

Traditional business loans amortize. Each payment consists of interest and principal, and as the principal balance decreases, the interest component shrinks. A merchant halfway through a loan term has paid down a meaningful portion of the principal and owes proportionally less interest going forward.

MCAs do not amortize. The daily or weekly debit reduces the remaining balance owed, but the cost of the advance does not decrease with it. Whether the merchant has repaid 10 percent or 90 percent of the total obligation, the cost per dollar of capital received remains identical. There is no benefit curve. The cost is flat from beginning to end.

This distinction matters most when a business owner considers refinancing or settling. On a traditional loan, the remaining balance shrinks predictably. On an MCA, the “remaining balance” is a proportion of a fixed total that was established at funding.

Disclosure Requirements Diverge

Federal law requires lenders to disclose the annual percentage rate on consumer and many commercial loans. The Truth in Lending Act mandates a standardized format that permits comparison across products. A borrower evaluating two bank loans can compare their APRs and arrive at a meaningful conclusion about relative cost.

MCA providers operate outside this framework. Because the merchant cash advance is structured as a purchase of future receivables, not a loan, the APR disclosure requirement does not apply in most jurisdictions. Several states, including California, New York, and Virginia, have enacted commercial financing disclosure laws that require something closer to APR equivalent reporting. But the federal requirement remains absent, and in many states, the factor rate is the only cost metric the funder is obligated to provide.

One does not need to attribute malice to the industry to observe that the absence of standardized disclosure favors the party with more information. And that party is never the merchant.

The Prepayment Asymmetry

On most traditional loans, prepayment reduces total cost. On most MCAs, prepayment reduces duration but not cost. This asymmetry operates in one direction only, and it favors the funder.

A business owner who receives a windfall, a large contract payment, a seasonal surge, might apply that cash to retire a traditional loan early and save thousands in interest. The same business owner applying the same windfall to an MCA saves nothing. The total owed is unchanged. The only benefit is that the daily debits stop sooner, freeing up future cash flow. But the capital cost of the advance has already been locked in and paid.

Some MCA agreements include early payoff discounts, typically small, and typically available only if the merchant requests them and meets specified conditions. These provisions are exceptions to the general structure, not features of it.

What Courts Have Begun to Recognize

The legal significance of these differences has grown as courts examine whether specific MCA agreements function as loans. When a transaction’s pricing structure mirrors that of a loan, when payments are fixed rather than contingent, when the factor rate produces an effective annual cost that exceeds usury thresholds, courts have increasingly been willing to look past the contractual label.

The Second Appellate Division in New York found in 2024 that an MCA agreement constituted a criminally usurious loan, noting that the effective interest rate exceeded the state’s civil usury cap by a wide margin. The Yellowstone Capital settlement in early 2025, which exceeded one billion dollars, arose from allegations that the company had disguised loans as MCAs with effective rates reaching 820 percent.

These developments do not mean every MCA is a loan. They mean that the distinction between factor rates and interest rates is no longer merely academic. It has become a question that courts answer, with consequences for both the funder and the merchant.

The six differences described here are not technical details. They are the structural reasons why a merchant cash advance at a “low” factor rate can cost more than a traditional loan at a “high” interest rate. Understanding the distinction is not optional for any business owner evaluating financing options. It is the precondition for an informed decision.

A consultation with our office produces the calculation the MCA provider did not offer. A first call costs nothing.

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