How a line of credit works
A lender approves a limit, and the business draws on it as needed. Interest is charged on the balance drawn, not on the limit, and repaying the balance makes the money available again. Banks offer lines to established businesses with good credit and financial statements; online lenders offer smaller lines on less paperwork, at a higher rate and usually with weekly payments.
How a merchant cash advance works
A funder buys a share of the business's future sales for a lump sum today. The total to be repaid is fixed at the start by a factor rate: $50,000 at a factor of 1.30 means $65,000 repaid. Repayment is a fixed daily or weekly debit from the bank account, or a percentage of card sales. Because approval rests mostly on deposits, an advance is available to businesses that do not yet qualify for a line, and it can fund within days.
Comparing the cost
A factor rate looks small next to an interest rate, but the comparison is misleading. The cost is paid over a few months rather than a year, and the balance falls with every payment. The $50,000 advance above, repaid in equal business-day debits over six months, works out to an annual rate of about 110 percent. California and New York, among other states, now require providers to show an estimated annual percentage rate, which makes the comparison easier.
When each one fits
- A line of credit, for a recurring need: payroll between payments, seasonal inventory, the gap between invoicing and being paid
- An advance, for a short need with a clear return, when speed matters more than cost and a line is not available in time
- Neither, for long-lived assets: equipment and real estate are cheaper financed against themselves
The risk to watch
Businesses get into trouble with advances when they take a second or third before the first is repaid, each payment coming out of the same deposits. If the daily payments have started to crowd out the business, consolidating them is usually the next step.