For small business owners, small business loans are not uncommon since the pressure to make ends meet can be enormous. If your business needs funds quickly, a merchant cash advance (MCA) can be extremely tempting. MCA companies offer fast cash—sometimes in as little as a day—in exchange for a slice of your business’s future revenue, or fixed daily repayment amounts that seem manageable. But MCAs can easily become a debt trap that forces borrowers to take out another MCA to pay off the first, and then another, and another, until one little advance to cover a shortfall becomes an all-out financial disaster.
How do MCAs work?
MCAs operate in one of two ways:
- They give you a lump sum up front in exchange for a set percentage of your future credit and debit card revenue until the advance and additional fees have been repaid.
- They give you a lump sum up front in exchange for fixed daily or weekly payments, which they automatically deduct from your bank account as an ACH withdrawal.
In either case, the repayment term is typically less than 12 months, and the APR (which they typically don’t share with you), can easily reach into the triple digits. In that way, they are a lot like payday loans for businesses. And the similarities don’t end there.
Like payday loans, MCAs target business owners who would have a hard time getting a loan from a traditional lender. In fact, their popularity exploded in the wake of the Great Recession, when banks were facing increased scrutiny and became hesitant to give loans to anyone seen as even slightly risky.
Maybe you have poor credit. Maybe your business hasn’t been around long enough. Maybe you simply need the money faster than a bank would possibly give it to you, and you have bills that need paying, inventory that needs ordering, and employees waiting on their paychecks. Then you get a phone call from a broker who says they can get you $50,000 in 48 hours—interest free! You can see how easy it would be to say yes.
What MCAs don’t tell you (in addition to the various terms they often fail to disclose or intentionally obfuscate behind confusing language) is that they are generally set up to skirt usury laws and financial regulations to push you into accepting triple-digit APRs, and if you fall behind on repayment even once, their collection tactics will be merciless.
When is a loan not a loan?
MCAs are technically considered sales, not loans. They look an awful lot like loans, and even industry insiders still use terms like “borrowers” and “lenders,” but really, they swear, they’re not loans. The MCA company is buying a share of your company’s future revenue.
That little distinction has massive implications, because it means MCAs are not subject to the same regulations and oversight as loans. These companies get to skip the hassle of complying with the Truth in Lending Act, for instance, and they can make it as difficult and confusing as they like to figure out exactly how much their advance will really cost you.
For example, MCAs don’t even express their rates like a typical loan. Instead of an interest rate expressed as a percentage—which can be confusing enough to interpret, but at least it’s a format that borrowers expect—MCAs present borrowers with a “factor rate,” which is expressed as a decimal, usually between 1.2 and 1.5. Multiply the amount of the advance by the factor rate, and you get the amount you’d actually need to repay.
Find help clearing business loans, including predatory merchant cash advances, for pennies on the dollar.
So, a $50,000 advance multiplied by a factor rate of 1.4 would give you a final repayment amount of $70,000. MCA companies calculate the factor rate for your advance based on your credit rating and other risk factors that bear a striking similarity to what traditional lenders consider before setting the interest rate on a loan. But in this case, the extra $20,000 beyond your initial advance is called fees, not interest. (Because, they say, this isn’t a loan. Honest.)
If that $70,000 comes with $300 daily payments, withdrawn directly from your bank account, then you would theoretically repay in full in 234 days, or a little under 8 months.
That gives this advance an effective APR of 112.24%. In the world of MCAs, that is considered low. In the world of most traditional loans, it would be considered illegal.
Springing the debt trap
Like payday loans, MCAs base their repayment plan on your presumed future income. And, also like payday loans, if your income isn’t as high as you hoped, you can quickly find yourself underwater.
Imagine you’re repaying your MCA through 15% of your daily credit and debit card revenue, but that 15% turns out to be more than you can afford to give up—not an unlikely scenario since MCA companies aren’t known for scrupulously evaluating borrowers’ finances before offering them the advance.
Or maybe you’re repaying through fixed ACH withdrawals that come out of your account daily and your business hits a slow season and now those daily amounts are more than you can bear. Or maybe you just encounter an unexpected expense—broken equipment, a damaged storefront, shipping issues, you name it.
Suddenly, those daily repayments are more than you can afford. You need more cash, and you need it fast. And if an MCA was your only option for a loan a couple months ago, there’s a good chance that it’s your only option now. So you take out another MCA to cover the first one and your current budget crisis. And it just escalates from there.
These snowballing advances are a feature of the MCA industry, not a bug. MCA insiders aren’t subtle about it.
“These renewals of Merchant Cash Advance Agreements, and making of new agreements with existing merchant customers, are an important source of revenue.”
-Yellowstone, one of the biggest MCA companies in America, In a lawsuit that they filed against a group of debt reduction companies
Think about that. MCAs are presented as a quick and simple way for small businesses to overcome a cash shortfall. Get the advance, pay it off in tiny increments, and you’re done—that’s how they sell it. But one of the giants of the industry argued in court that their business depended on getting people who already have MCAs to take out new ones.
If you're reading this blog, you probably would not be surprised to learn that MCA companies use the dame debt collection tactics as more typical lenders. But unlike other lenders, MCA companies have a nasty weapon in their arsenal: The Confession of Judgment or COJ.
MCAs are touted as “unsecured,” which sounds great on paper—they can’t take your house if you miss a payment! But many MCAs make borrowers sign a COJ, a document that says that if the MCA company accuses you of failing to pay, you won’t contest it in court.
The moment a payment is late, the company can rush to file a lawsuit that can let them freeze your accounts and seize your assets. They often file out of state to make things more complicated for the borrower, and because COJs forfeit the right to contest, the judgment can happen so fast that borrowers can lose everything before they even know a suit has been filed against them.
Like MCA giant Yellowstone explained above, the MCA industry depends on borrowers taking out multiple advances, sometimes from multiple companies. But the first MCA company to file suit using a COJ gets to seize all the assets. That creates a dangerous incentive for companies to use COJs to file suits as quickly as possible, before another company beats them to the punch. As NPR reported, Yellowstone, which has filed over 5,000 COJ suits, has even used COJs to obtain judgments against people who haven’t even missed a payment yet.
If you think COJs sound a lot like signing your rights away and ought to be illegal, you’re not alone. A bipartisan bill to ban confessions of judgment for small business owners generated some excitement when it was introduced in the Senate in December, 2018, but died in committee.
A better way
Look, businesses need capital to survive. We get it. And if your credit isn’t the best, an MCA may be the most appealing option. But just like with payday loans, before you enter into an MCA, you should make absolutely certain that it’s the only option available, and you need to be 100% sure that the repayment schedule is not going to put you further into a hole, even if an emergency expense pops up.
One thing you can do is use an MCA APR calculator to figure out the effective APR of the advance. Would you accept a loan with that APR? If not, then it’s probably time to walk away from the deal before it’s too late. The rise of online lending has led to the growth of the MCA industry, but it also means there are other lenders out there who may be willing to offer you better and more honest terms for your specific needs and circumstances.
If you’re already facing unaffordable business debt, whether it’s from an MCA or another source, just know that COJ or no COJ, you still have rights. And one of those is the right to fight back against aggressive, misleading, and illegal collection practices.
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