The Difference Between a Merchant Cash Advance and a Loan

With more business funding options now than ever before, it can be difficult to decide which one works best for your growing business. In this article, we’ll go back to basics and discuss the differences between a merchant cash advance and a loan, two funding methods that can be misunderstood. 

In this post, we’ll cover:

• The difference between a merchant cash advance and a loan
• Traditional term loans defined
• Types of traditional loans
• Lines of credit
• Merchant cash advance
• Choosing the right funding source

What is the difference between a merchant cash advance and a loan?

A merchant cash advance (MCA) is not a loan; it’s the purchase of future receivables. Businesses are given upfront working capital, which is then remitted through a percentage of the revenue generated by daily credit and debit card sales until the advance is fully remitted. 

This means a merchant does not owe any funds until they generate sales. This flexibility provides great relief from the financial stress that may come with the other types of small business funding that we described earlier.

On the other hand, a loan is money that financial institutions lend to a business that is paid back over a scheduled term over time, with interest. There are several types of loans, which we’ll discuss in detail. 

Simply put, an MCA does not qualify as a loan because it’s a sale of future revenue. Because of that technicality, it’s not subjected to the scrutiny or regulations imposed on a standard small business loan. That means cash advances are a quick and easy way for merchants to acquire the cash flow they need, rather than waiting for a bank’s rigorous and slow approval process. Nor does it require a traditional payment schedule, and your credit score plays no role in whether or not you qualify. In a nutshell, those are the differences between a merchant cash advance and a loan.

For a quick overview of the differences, refer to the table below. 

What are traditional term loans?

When your business needs capital, your next thought may lead you to a bank loan, and rightfully so. Traditional banks have honed the art of lending for centuries. Whether you want to buy land, build a house or start a business, if you need capital, you go to a bank.

You apply for a business loan, provide the necessary requirements, and if approved, the bank gives you a lump sum of cash in exchange for making monthly payments over a set period of time, or ‘term’, with a fixed or variable interest rate over the life of the loan. Depending on the term of the business loan, it would then be further sub-categorised as either a long-term or short-term loan. 

Types of traditional loans

Long term loans

Long-term loans are, you guessed it, loans with a repayment period significantly longer than what’s considered a short-term business loan. Repayment for a long-term business loan can be anywhere from five years to a decade or more.

Approvals for long-term loans are harder to come by because you have to contend with the strict qualifying standards of traditional banks. Most likely, you will also have to put up collateral, and the bank may limit the amount of loans the business can take on in the future. Also, not only does your business have to be in good standing and have the financial statements to prove it, but your personal credit score will also have to be outstanding.

Long-term loans make more sense for established businesses with a stable business credit history that are looking to expand or acquire another company. In addition to the longer repayment term, these loans are generally higher dollar amounts (six figures is common) and can have a lower interest rate than short-term loans. 

However, borrowers should be aware that the lower interest rate over a longer period of time can equal or surpass that of a short-term business loan over its lifespan, significantly increasing the repayment amount. Just do the math.  

Short-term loans

Small business owners typically go with short-term loans, even if they’re just starting out. A short-term loan is structured to provide more immediate funds. Short-term loans are typically smaller amounts, have a slightly higher interest rate than long-term loans, and, you guessed it, have a shorter payback period that can last a few months to a few years.

Short-term loans heavily rely on your personal credit and may require you to put up collateral if you’re going through a traditional financial institution such as a bank. However, on the bright side, there are more alternative financing sources for small business owners other than banks, but more on that later. That makes them easier to obtain even if you don’t have the best personal credit score or collateral to put against the loan. 

The difference between short and long term loans

Short-term loans are used for working capital needs, like buying inventory, marketing expenses, and payroll. The use of funds is tied directly to generating revenue and can, therefore, be paid back earlier. In other words, you use the loan for a business initiative that generates revenue quickly, which makes the higher interest rate less of an issue.

Long-term loans are used for expansion and growth. Initiatives like remodelling, buying equipment and buying out a partner are excellent reasons to take out a long-term loan. Since the initiatives aren’t directly tied to revenue generation (you aren’t using a long-term loan to fund a marketing campaign), they need a longer payback period to soften the blow of larger fixed monthly payments. 

Secured and unsecured loans

Secured loans require collateral. The idea behind collateral is that it becomes a security net for the bank. If you want the bank to lend your business the money, they may require you, the borrower, to pledge a piece of real estate or your assets, such as inventory, to ensure repayment. If you default on the loan, the bank has the authority to seize the assets or real property in order to repay the debt. When you pledge collateral against a loan, it’s called a secured loan. This means the bank is securing itself from losing out on as little money as possible.

On the other side of the spectrum, you have unsecured loans. Unsecured loans do not require the borrower to put up collateral. They are heavily based on your personal credit score and slightly based on the relationship history the borrower has with the lender.

Since you’re not providing the lender with any assets or a property-based security blanket, they are considered a bigger risk. We all know that a bigger risk means a bigger reward, right? So, from a lender’s perspective, a bigger reward means a higher interest rate for you, which equals more (bigger) money (reward) for them.

Along the same lines, because you’re not putting up any collateral, you will be required to sign a personal guarantee (PG). A personal guarantee means that you are personally responsible for loan repayment. Not the business, not another stakeholder, or another partner. If you signed on the PG line, you are responsible for repayment.

Long-term loans are almost always secured, while short-term loans could go either way depending on your credit score, relationship with the bank, and willingness to sign a personal guarantee. Lines of credit can also work in this manner where they are either secured or unsecured, which brings us to our next point.

Lines of credit

Lines of credit are worth mentioning here because they are a version or subcategory of a short-term business loan but with a slight twist. They’re similar to a credit card in that once the lender approves you for a certain amount, it remains at your disposal. A line of credit is primarily used for working capital needs. They’re great for inventory purchases and operating expenses, or they can also be used as general cash flow or capital if you’re in a pinch due to slow sales. A line of credit is a valuable option for both smaller and growing businesses.

Unlike a loan, where you have to reapply once you use the funds, a line of credit is revolving and quite flexible. This means that if a bank decides to extend a line of credit to you for $30,000 and you take $10,000 to buy more inventory or invest in marketing to grow sales, you still have $20,000 left to use or not use. The bank will charge interest on that $10,000 until it’s paid off. When you pay down that $10,000, your credit line goes back to $30,000 without having to reapply like you would for a loan. So, even if you don’t need the cash right away, opening a line of credit sooner rather than later is a smart idea. It’s your security net.  

Merchant cash advance

Up to this point, we’ve talked about different types of loans: short and long, secured and unsecured business loans and even revolving lines of credit. Remember how we mentioned there was a bright side to short-term loans? There are alternative financing sources for small businesses besides loans and lines of credit. Merchant cash advances (MCA) have been around since the 1990s, and businesses in the merchant cash advance industry have pioneered alternative financing. As we mentioned earlier, MCAs aren’t traditional business loans. 

We know what you’re thinking–how can someone or some company buy a percentage of your future revenue from credit card sales or receivables and intercept that money automatically before you ever see it? Enter your payment processor, a.k.a. your credit card processor. 

Credit card processors began partnering with merchant cash advance companies to make transferring funds easier and faster for merchants. Since payment processors already had access to a merchant’s funding account for credit card sales, it made sense to use them to streamline the cash advance process. In some cases, payment processors offer the service and funding in-house to complement their core business offering. This became more mainstream in the early to mid-2000s.

Benefits of an MCA

There are many benefits to an MCA over a loan for small business owners. 

Easy application process

Because they are not dependent on credit scores, it’s much easier for a merchant to be approved for a merchant cash advance than a loan. The application process for a loan is also often a lot more time-consuming and complex. There’s also no traditional collateral required for MCAs. Business loans typically require you to create a detailed business plan about what you’re using the funds for. With an MCA, as long as it’s being used for anything business-related, you’re good to go. 

Relief for businesses with fluctuating sales

Since a merchant cash advance is fulfilled based on a percentage of your future credit card sales, rather than a fixed amount, the actual amount the provider collects changes from month to month. This can be very beneficial for a merchant managing their cash flow. If you go through a slow season, the collections made on the cash advance decrease. If sales skyrocket, the collections increase. However, the percentage that is collected never changes, keeping your business cash flow stable. With loans, you have a fixed repayment amount, which can put a serious dent in your bank account if you’re going through a sales slump.

Get funds faster

It may take a while to secure a loan compared to an MCA. After your initial application is approved, it typically only takes a few business days to see the cash advance in your account. From there, you can use the advance for any business project or expense. 

Flat-fee structure 

One of the perks of an MCA is that it typically comes with a one-time flat fee that’s remitted alongside the advance amount. The two together are known as the “purchase amount”. This stands in contrast to loans, where you may encounter fluctuating interest rates or extra fees if a payment is made late. 

We know merchant cash advances can give your business exactly what it needs without complications. That’s why we offer top-rated, lightning-fast, merchant-first financing with Lightspeed Capital. 

Our merchant cash advance program provides upfront funding for growing businesses. 

Take Lightspeed retailer The Brande Group, which has used Lightspeed Capital several times. The nature of their business is fast-paced: they cater to a wide customer base and carry trendy apparel at a discount. As a result, they need to have cash on hand to make immediate inventory purchases, which they’re able to do with Lightspeed Capital. 

By taking advantage of their cash advance offers to purchase inventory in advance at a greater discount, they’ve been able to improve their profit margins. 

“[Lightspeed Capital] helped us get products at a lower cost in order for us to make more profit selling the product,” says company president Tyan Parent. “We were able to get between 20 to 30% better margins on the product that we purchased ahead of time due to [Lightspeed] Capital.”

Did you know? Exclusive to eligible Lightspeed merchants, Lightspeed Capital provides cash advances in as few as two business days. The application process is simple: you can apply in your POS dashboard in just a few clicks.

Blurring the line between cash advances and loans

Thanks to the success and popularity of merchant cash advances, traditional small business lenders were forced to step up their game and offer fast and flexible loans in order to stay competitive.

The quickness of cash advances alongside technology helped disrupt the traditional financing industry and opened the doors for a relatively new industry of online lending. Online lenders offer various services and financing options that resemble the ease and speed of a cash advance. The emergence of these alternative resources gives merchants like you a lot more resources for capital, cash flow needs, operating expenses and marketing campaigns. 

Cash advance or loan? Which is right for my business?

Now that you know the difference between a merchant cash advance and a loan, how do you decide which is right for your business? The answer is it all depends on you and your unique business needs. Here are a few things to consider to point you in the right direction. 

Credit

Your personal credit is a key component to help you establish business credit. Since loan repayments or lack thereof are reported to credit bureaus, if you don’t have great personal credit, it may be harder to obtain a loan from traditional sources. If your credit is less than stellar, a merchant cash advance may be the better option. 

Profits and credit card revenues

Banks will look at your business’ overall profits and number of years in business as factors in determining whether or not you qualify for a loan. Companies that provide merchant cash advances are also interested in the amount of time you’ve been in business, but they’re more interested in your credit card revenues. 

Fulfilling your agreement

To repay a traditional loan, you pay monthly instalments of a fixed amount due at the same time each month. Cash advances are different. The advance is remitted at either daily or weekly intervals, and the amount fluctuates based on your credit card revenue. If you prefer to wait until you make money to fulfil your agreement, a cash advance would be the better option. If you’re seeking a firm repayment schedule, a loan is the better choice. 

Use of capital

Merchants like you will need capital for a variety of reasons. Maybe you need to buy new seasonal inventory and run a marketing campaign, which are ideal uses for cash advances because you anticipate making your money back relatively quickly. Maybe you’re planning to open a new store location. Maybe you need to buy some new equipment or just need a little extra cash flow during your slow months. If that’s the case, a loan or a line of credit from the bank may be the better option. 

Did you know? Lightspeed Capital assesses merchants' eligibility for a cash advance on a monthly basis. Check your Back Office for your offer, or reach out to your account manager for more information.

Looking for funds?

We’re proud to drive serious growth for our retail and hospitality merchants with Lightspeed Capital. Are you a Lightspeed customer looking for funding for your retail business? Talk to a Capital expert to get started.

FAQ

What is the difference between a cash advance and a payday loan?

A merchant cash advance is a lump sum provided to a business in exchange for a percentage of future credit card sales, while a payday loan is a short-term, high-cost loan designed for individuals, typically repaid on their next payday.

Are merchant cash advances ever a good idea?

Merchant cash advances can be beneficial for businesses with consistent credit card sales in need of quick capital. However, businesses can be deterred by higher flat fees. Businesses should carefully assess the process and consider all financing options before opting for a merchant cash advance. 

What are the disadvantages of a cash advance?

Disadvantages of a cash advance include a potentially high flat fee and the absence of a grace period.

Is a merchant cash advance considered a loan?

A merchant cash advance is not a loan. It functions as a cash advance based on future credit card sales. It involves receiving a lump sum in exchange for a percentage of daily credit card transactions, with fees and the remittance process differing from standard loans.

Why would you use a cash advance?

Businesses may use a merchant cash advance for quick access to capital, especially if they have consistent credit and debit card sales. It’s chosen for its speed, flexibility, and accessibility, but businesses should be aware of potentially high costs.

Do cash advances hurt your credit?

Merchant cash advances typically don’t impact your credit score directly, as they are based on business sales. However, if you struggle with repayments and default, it may affect your personal and business credit in the long run.

How much is a typical merchant cash advance?

The amount of a typical merchant cash advance is often a percentage of the business’s daily credit card sales, ranging from 10% to 50% of monthly revenue. The specific advance amount depends on factors such as business performance and the agreement with the provider. 

Editor’s note: The content in this post is intended for informational purposes only and should not be considered legal, financial, or tax advice. We recommend consulting with a qualified legal or accounting professional for personalised guidance. Where available, we have included primary sources to support our information. We strive to ensure accuracy; however, we cannot be held liable for any actions taken based on this content. Please note that Lightspeed does not commit to updating or verifying any new changes to the information in this blog post after its publication.