Invoice factoring is a form of business financing that makes it possible for small businesses to get funding using unpaid customer invoices. If you’re considering invoice factoring, it’s important to understand how it works and the costs associated with it. 

Here’s what you need to know.

What Is Invoice Factoring?

Invoice factoring is a type of financing that you can get utilizing unpaid invoices from your customers and clients. With invoice factoring, you’ll sell some or all of your accounts receivable to a third-party factoring company, which will pay you a portion of the invoice as a lump sum.

The factoring company then takes over the collection of your invoices directly from your customers or clients. Once it’s collected the payment, it’ll pay you the remaining amount minus its factoring fee.

Because you’re selling your invoice instead of using it as collateral, invoice factoring is technically not considered a loan.

Invoice factoring is sometimes also referred to as debt factoring or accounts receivable factoring. However, it’s different from invoice financing, which we’ll cover in more detail later.

How Invoice Factoring Works

If your small business makes money through invoicing customers and clients instead of collecting upfront payment, you may allow them to pay on a net-30, net-60, or even net-90 basis.

But if you have outstanding invoices that aren’t yet due and you need cash urgently, invoice factoring can be a way to get what you need. 

You’ll typically receive between 80% and 90% of the invoice amount up front and assign the role of collecting the payment from the customer or client to the factoring company.

Once the factoring company has collected the payment, it’ll give you the remaining amount minus its factoring fee, which usually ranges from 1% to 5%. 

The factoring fee will depend on various factors, including your sales volume, the creditworthiness of the customer or client, and whether you or the factoring company is responsible if the invoice goes unpaid. 

For example, let’s say you have an invoice for $5,000, and it’s due in 30 days, but you need the money sooner. So you sell it to a factoring company, which agrees to buy it for $4,800, taking a 4% fee. It gives you $3,840 upfront, then the remaining $960 when it collects the payment.

Typical Invoice Factoring Costs

Factoring rates can vary from 1% to 5%, which doesn’t sound like a lot. But considering it typically takes between 30 and 90 days for the factoring company to collect payment on the invoice, the short-term nature of this financing option can result in a high APR.

What’s more, some factoring companies may charge additional fees, such as an application fee, processing fees for each invoice, credit check fees, late fees, and more.

The more fees that get added to your factoring contract, the more expensive it will be. 

Invoice Factoring Pros

There are several reasons business owners rely on invoice factoring to get help with short-term cash needs. Here are some of the benefits you can take advantage of:

• Fast funding: Traditional business loan options can take weeks or even months to fund, but if you can wait that long, you can usually wait until your customer pays their invoice. If you need the money urgently, though, invoice factoring can be a quick and easy way to get access to money that you’ve already earned.
• Easy approval: If you have poor personal credit, a limited history of time in business, or a lack of collateral, you may have a hard time getting approved for most forms of business financing. However, invoice factoring companies underwrite primarily based on the creditworthiness of the customer paying the invoice and your sales volume. So it’s possible to get approved even if you can’t get alternative financing options.
• No collateral required: Invoice factoring is a form of unsecured financing, so you don’t have to worry about putting up any collateral to secure the funding. 
• Improved cash flow: Invoice factoring makes it possible for you to maintain your payment terms with your customers and clients, which can keep them happy. At the same time, you’ll still get access to that cash flow when you need it, even if it’s at a discounted rate.

Invoice Factoring Cons

Despite the clear advantages to using invoice factoring to boost your cash flow, there are several pitfalls to keep in mind that may make you want to think twice before you apply:

• It’s expensive: As previously mentioned, invoice factoring may seem inexpensive at first because factoring fees usually cap at 5%. But since it’s a short-term form of credit, that can translate into a high APR. You’ll also want to watch out for extra fees in the contract and shop around to ensure that you find the most inexpensive option.
• It doesn’t work for B2C businesses: Invoice factoring is an option if your business works exclusively with other businesses. But if you’re working directly with consumers, it’s unlikely that you’ll be able to take advantage of invoice factoring.
• You lose control of the collection process: When you use invoice factoring, the factoring company takes over the collection of the invoice. If this results in a poor experience for your customer or client, it could damage your relationship. Make sure you work with factoring companies that use ethical and fair collection practices.
• Your options are reliant on client creditworthiness: If you try to factor an invoice from a client that has a poor credit history or weak revenue, the factoring company may deny your application. Unlike traditional forms of business financing, you can’t rely on your own responsible credit habits to get approved.
• You may be forced to buy it back: If the customer or client refuses to pay the invoice and it’s a recourse factor, the factoring company may force you to buy back the invoice or replace it with another invoice that has equal or greater value. If this happens, it could disrupt your cash flow.

Invoice Factoring vs. Invoice Financing

As you’ve done your research, you may have come across both invoice factoring and invoice financing, and it’s important to note that these are two different financing options.

With invoice financing, you don’t sell your accounts receivable to a third party. Instead, you use outstanding invoices as collateral to obtain a loan. 

Unlike invoice factoring, invoice financing allows you to retain control of the collection process, so you don’t have to worry about your customers or clients getting a bad experience.

Typically, you’ll receive up to 85% of the original invoice amount upfront with invoice financing, though that percentage can vary from lender to lender. 

Then, once you’ve received the payment from your client or customer, you’ll pay the lender, and it will provide you with the remaining invoice balance minus any fees. You’ll typically pay a processing fee, which is about 3%, plus a weekly factor fee of 1% to 2% until the loan is repaid.

Like invoice factoring, invoice financing can be an expensive way to get capital, especially if it takes longer to get payment on the invoice you’re using as collateral for the loan. But if you need the money urgently and don’t have a lot of options, it can be worth the extra cost.

Build Your Business Credit to Have More Financing Options

If you’re considering invoice factoring or invoice financing, your cash flow needs might be urgent enough that you don’t have time to qualify for other financing options. 

But over time, it’s a good idea to focus on your business credit scores as a way to open up more opportunities to get the capital you need, preferably at a lower cost to you.

One way to do that is to use business credit cards or vendor credit, both of which are possible to obtain, even if your business is relatively new and doesn’t have a lot of revenue or operating history. 

You can also take advantage of online business loans and lines of credit, though these can be more expensive than even business credit cards if you’re not careful.

Another option to consider is a Credit Strong business credit builder account. This can be a great way to build business credit because it’s affordable and provides long-term reporting. Here’s how it works:

• Apply and choose a repayment term, which can be as long as 120 months.
• Receive a response in minutes. If you’re approved, the loan amount will be locked in a business savings account to act as collateral.
• Make your monthly payments, which will be reported to several commercial credit bureaus.
• Once you’ve paid the loan in full, you’ll receive the loan funds, which you can use however you want.

If you change your mind, you can cancel your account early and get credit for your monthly payments up to that point. 

Regardless of how you go about it, it’s important to be proactive about building your business credit history so that you’ll have access to more favorable financing options in the future when you need them.

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