The True Cost of Small Biz “Loans”: Square, PayPal, & Kabbage

Calculating the real interest rates of Merchant Cash Advances

Merchant Cash Advances have become very popular among micro-businesses because they are the only working capital financing option available to them. PayPal has loaned $500M in 18 months, and now has a $730M run-rate. Square has loaned over $100M, and is now loaning at a $275M run-rate. Although they’ve become mainstream through offerings from Square, PayPal, and Kabbage, this form of capital is often extremely expensive and hidden behind of veil of seemingly simple and low fees. A cash advance is typically the equivalent of borrowing at a 30–70% interest rate-or even higher. This article looks in-depth at the numbers behind these companies.

What are these things?

A Merchant Cash Advance is a distinct lending product that (1) is not technically a loan, (2) doesn’t build business credit, and (3) carries a “fee” on the principal amount rather than the interest rate of a traditional loan. Where a bank loans $1,000 at 10% interest, Kabbage, for example, will loan you $1,000, and demand repayment of the $1,000, plus a 10% fee, totalling $1,100. Kabbage requires payback in 6-months, but the fees are front-loaded in the first 2 months. PayPal and Square take a percentage of sales until the advance is repaid.

Although Kabbage, Square Capital, and PayPal Working Capital have received a lot of press, news sites either ignore how expensive they are, or incorrectly equate the fee amount with the effective interest, as Re/code did. The “catch” of a cash advance is the fact that the fee is often fixed. While repaying a loan will reduce the principal (and therefore interest payments), repaying a cash advance early will simply increase the effective interest rate. The following section explains the effective interest rates of three key offerings:

Effective Interest Rate of Merchant Cash Advances

The Kabbage website shows an example loan of $10,000, with a fee of $1,200 and repayment outlined below:

With the total fee of 12%, it doesn’t seem like a bad deal at first glance, but we must take into account the time value of money. Because much of the fee must be paid back in month 1 and 2, the effective interest rate of this example is a sky-high 52%. Given that they charge between 1% and 13.5% for each of the four months, their effective interest rate can reach 204%. It should be noted, however, that if you repay everything in month 5 (using the example above), you avoid the $100 month 6 fee, but doing so only lowers the effective rate to 50%.

PayPal Working Capital

PayPal’s offering makes repayment easy by garnishing income- taking 10%-30% of your daily income. As you can see with the graphic below and on their website, the loan fee decreases as you pay a higher percentage of sales to PayPal. The examples here yield an effective interest rate from 31%-33%, with payback ranging from approximately 3–12 months.

Note that this calculation assumes daily pay back, evenly distributed across payback period- early repayment would only increase the effective interest rate.

Square Capital

Square Capital is set up very similarly to PayPal, with a range of fees from 10% to 14%, and payback coming as a percentage of sales. Assuming a payback period range from 6–14 months, the effective interest rate could range from 18% to 71%. Given that they likely offer lower fees to customers who will pay back quickly, the likely range is 22% to 59%.

This example also assumes daily payback and even distribution of sales (no seasonality).

So what does this mean for small businesses?

Merchant Cash Advances are expensive forms of loans! When a business borrows money at such a high effective interest rate, they should only use the money to fund projects/products that produce even better returns. Growing a business under the burden of 50% interest is very difficult. But they do serve a purpose: Many businesses take these cash advances because they aren’t eligible for any other forms of credit. So it’s ok for them to take an advance, as long as they understand the true cost. But…

Small businesses should know the alternatives: When weighing a loan at an effective interest rate of 30% or 50%, credit cards look very cheap, although hidden fees can easily wreck that logic. There are also numerous other well-known lending platforms like CAN, Lending Club, Amazon Lending, OnDeck, and Funding Circle, that offer various loan (and merchant cash advance) products.

It’s also important to note that cash advances have downside protection. Customers benefit from two main elements: (1) Merchant cash advances are not technically loans, so if you pay late-or not at all-it won’t necessarily ding your credit. (2) For cash advances that are paid back using a percentage of sales (Square & PayPal), if your sales drop, you pay less (and your effective interest rate drops).

Photo credit: Miran Rijavec

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