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What is Invoice Factoring?
Invoice factoring is a type of financing in which one sells the invoice of a customer, who owes money, at a discounted rate to get capital in the present. The lender gives the borrower an advance on the invoice usually between 70-85% of the invoice’s value. When the invoice is paid off the borrower gets the withheld percentage minus a fee. Due to the high administrative costs of invoice factoring, it is best suited for businesses that have large contracts with other businesses or the government.
An advantage of invoice factoring is that it does not rely on your credit rating. Since the customer is the one responsible for repaying the invoice, it is their credit, not yours that is taken into account.
Some lenders ask for a monthly factoring minimum. This minimum puts you into a contract with your lender, which sets a minimum amount of invoices that they factor every month. If you do not meet that minimum, you will be fined.
Lenders will likely ask for a minimum size of individual invoices, since the processing and administrative costs may outweigh the gains of a small invoice. If you have a monthly factoring minimum the minimum size for individual invoices will likely be smaller.
With conventional loans most of the cost comes from interest and a small portion of fees, invoice factoring most of the cost comes from a single fee and sometimes charges no interest at all.
The factoring fee is the percentage of the invoice the lender keeps for themselves for their services. Generally, the factoring fee ranges between 1-5%. The size of the fee is partially dependent on the credit score of the customers being invoiced, the better their score the lower the rate.
Another contributor to your factor to the fee is the whether the factor is recourse or nonrecourse. A recourse factor is one in which the borrower has to compensate the lender for an invoice left unpaid after a certain time frame. The compensation either comes in the form of buying the invoice back from the lender or exchanging it for a new invoice. Nonrecourse factors have no such protection for the lender and therefore tend to have higher rates.
If you have a contract with a monthly invoice minimum, you will likely have lower factoring fees. However, if you fail to meet the monthly minimum the fee you will receive will probably be more than the savings you made from the reduced fee.
You will sometimes see invoice factoring expressed as an APR. This APR is often much higher than a conventional loan. While that’s worth considering when making your financing choices, it is also worth noting that invoice factoring is a very short-term loan, so the total cost of capital may be lower than a longer-term loan with a lower APR.
Discount Rate (Factor Rate)
Sometimes, in addition to the factoring fee, there are fees for invoices which are not paid within a certain time frame. There are two ways a lender can charge for factors which do not get paid quickly.
The most common method is the discount rate. For this method, the only charge if the invoice is paid within the time frame is the original factoring fee. After the time frame has passed the fee is increased at regular intervals, usually around 1% per week.
The other method is the prime plus method. In this case, interest begins to be charged on the loan immediately and remains constant until the invoice is paid. The interest on these loans is relatively high, around 12% APR, but this type of payment is lower than the discount rate if it goes beyond the expected time frame.
Invoice Factoring vs Invoice Discounting
The main difference between invoice factoring and invoice discounting in who controls and collects the invoices. When an invoice is factored the lender takes control of the invoice, and it becomes their responsibility to collect from the customer. When an invoice is discounted the invoice is used as collateral for the loan, and it remains under the control of the borrower. Some borrowers prefer to invoice discounting because it allows them to collect from their own customers and keep their need for outside financing discrete. Since the invoice is repaid by the customer in invoice factoring the credit of the borrower does not come into consideration, which is an advantage for those with bad credit. With invoice discounting you pay the loan back at regular intervals and you take all of the risk that the customer fails to pay you back.
How Invoice Factoring Works
The first step of invoice factoring is to make an invoice for what your customer owes you. After you’ve issued the invoice, you can sell it to a lender. If you qualify, the lender will front you 70-85% of the value of the invoice. The lender will then contact the customer and arrange a payment method. Once the customer has paid the invoice, the lender will pay you the part of the invoice they had retained minus a fee (usually around 1-5%).