Both merchant cash advances and small business loans provide working capital, but have very different pros and cons.
When you’re looking for working capital, how do you know if a merchant cash advance or a business loan is the right choice?
You can use either for a variety of business expenses: purchasing stock, running ads or other marketing campaigns, investing in new equipment and more.
However, there are some key differences between the two options. Generally, business loans offer fees that are more favorable while merchant cash advances provide more flexible eligibility requirements.
Let’s look at each option in more detail.
Small business loans are a form of loan specifically for business purposes. Like all loans, they come with an interest rate and a repayment period. Together, the interest rate and the repayment period determine how much you’ll pay back for taking out a loan. The higher the interest rate, the more you’ll pay to borrow money.
Pros of Business Loans
Business loans have been a popular choice for funding, and there are several good reasons for that. Notably, loans often feature:
- Lower overall cost: Business loans through the Small Business Administration currently have interest rates of 8.25 percent or less.
- Fixed repayment amount: Some businesses find it easier to budget with a fixed monthly payment amount.
- Specified repayment term: Some businesses prefer knowing exactly how long it will take to pay off the loan.
- Ability to repay sooner: Business loans often allow for earlier repayment, allowing you to save on interest
Cons of Business Loans
However, there are some drawbacks to loans, as well. Possible negative factors include:
- Stricter eligibility requirements
- May require good personal credit
- In months with slower sales, you still owe the full monthly payment
Merchant Cash Advances
A merchant cash advance is different than a loan in that a lender essentially pre-purchases some of your credit card sales, “advancing” the money to you. Thus, the lender “owns” some of your future sales, and will collect the money from those sales.
Unlike loans, merchant cash advances technically don’t have an interest rate, or a set repayment period. Instead, the lender recoups the principal and its profit by taking a percentage of your credit card sales each day until you've repaid the balance and the fee agreed on.
For example, if you borrow $50,000, a lender may charge a $10,000 fee, and require 15 percent of your daily credit card sales until you’ve paid the full $60,000. Many people mistakenly think that the percentage of sales the lender takes is the same as an interest rate, but that’s not the case. Don’t make the mistake of thinking that a lower percentage of your sales translates into a low cost to take a cash advance.
Pros of Cash Advances
Merchant cash advances are catching on as a funding option, especially with high-visibility companies like PayPal offering them to even small businesses. Cash advances often feature:
- Less strict eligibility requirements: It may be possible to qualify for cash advances with poor personal credit even if you’ve been turned down for a loan.
- Repayment based on sales: Since the lender deducts payments from your credit card sales, if you have a slow day, you pay back an accordingly lower amount that day.
- No fixed repayment term: Money is simply deducted from your daily sales until you’ve met your repayment amount.
Cash advances generally require a strong history of credit card sales in place of good personal credit. You may have to show that you’ve been in business for a certain amount of time, and taking credit cards during that time. Lenders usually don't require collateral for cash advances.
Cons of Cash Advances
While there are some good things about cash advances, they aren’t without cons. Possible negatives to consider include:
- More difficult to budget accurately
- No option to repay sooner
- Often comes with a higher overall cost to borrow
Some businesses find it difficult to plan expenses when the daily total paid for the advance fluctuates due to varying credit card sales.
Which Is Better?
Ultimately, it will depend on your business.
If you qualify for a small business loan with a low-interest rate, that will almost always be your best option. However, if you struggle with approval for a business loan, or can only get approved at very high-interest rates or unfavorable terms, a cash advance may be a good alternative for you. If you need to find a merchant cash advance lender, you can start by contacting your credit card processor, or use a credit card processing company directory to locate cash advance providers.
In either case, make sure to carefully consider the pros and cons of both funding options. Cash advances may be easier to obtain, but they are still a financial obligation and should be taken seriously. Loans and merchant cash advances are generally not a great solution if you’re struggling to become or remain profitable, as they will provide a temporary influx of cash but will then cut into your sales since you’ll need to pay for the cash you received.