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What is Invoice Financing?

Invoice financing is a general term for a loan based on the money owed to a business by its customers. The lender forwards a percentage of what the customer owes in exchange for a fee. It is a useful tool for maintaining working capital while waiting for customers to pay. There are many different types of invoice financing but the two most common types of invoice financing are invoice factoring, and invoice discounting.

When a business uses invoice factoring, a lender forwards them a percentage of the invoice, usually 70-85%. The lender then collects the money the customer owes and then repays the borrower the remainder of the invoice, charging interest or a fee for their services. One of the drawbacks to this method of financing is that since the lender collects from the customer, it reveals to the customer that the business needed short-term funding. In some situations, this can look bad for the business that borrowed.

Invoice discounting, on the other hand, does not reveal that the borrower needed to take a loan. Similar to invoice factoring, the lender loans a percentage of the invoice, in this case up to 95%. However, with invoice discounting the invoice remains in control of the borrower. The borrower repays the loan (plus fees or interest) in regular installments regardless of whether or not the customer has paid his debt back.

Credit Requirements

Unlike most loans, invoice factoring does not take your credit history into account. Since the lender is collecting directly from your customers, the lender will use the credit history of your customer to determine the risk that it will not be paid on time.

Invoice discounting works more like a conventional loan. The invoices act as collateral, which the lender will take control of if the borrower fails to make their payments. Since the borrower makes the repayment, the lender uses both the borrower’s credit history and his customers (to assess the value of the collateral). Since the invoices are acting as collateral invoice discounting has less strict credit requirements than most unsecured loans. However, since the lender has to consider the risk that the customer fails to pay as well as the borrower, the credit requirements are more strict than loans with conventional forms of collateral.

Rates (%)

Due to the added risk and administrative cost of dealing with customer debt most forms of invoice financing have higher rates than traditional financing.

In most cases, invoice factoring withholds a factoring fee, which usually ranges from 1-5%. The size of the factoring fee is determined by the credit rating of your customer, and whether your factor is recourse or nonrecourse. A recourse factor is a factor which needs to be either repurchased by the borrower or replaced with a new invoice if the customer does not repay the invoice within a certain time frame. A nonrecourse factor offers the lender no such protection. Due to the increased risk, nonrecourse factors have higher factoring fees than recourse factors.

Invoicing discounts ask for weekly payments, charging as much as 1% per week in interest, regardless of whether the customer pays their debt or not.

How it Works

Invoice financing is a means of gaining capital based on money owed to you. Different types of invoice financing work in different ways.

Invoice factoring works by basically selling the invoices of what a customer owes you. The lender forwards a percentage of the cash, usually 70-85%, and collects the customer’s debt themselves. After that debt is collected the lender gives you the percentage they had withheld minus a fee called the factoring fee. Factoring fees are usually 1-5% depending on the type of invoice factoring and the credit rating of the customer. Since the borrower is not directly responsible for paying back the factor, the lender usually does not take their credit rating into account.

Invoice discounting functions similarly to a secured short-term loan. The invoices act as collateral, to be collected if the borrower fails to pay back the loan. The borrower still collects from their customer and is in full control of this collection. The borrowers repays the loan plus interest, usually in weekly installments.

Since these loans are smaller and for a shorter term, the application process tends to be much quicker. Some borrowers get approved on the same day as they apply.

Invoice Factoring vs Invoice Financing

Invoice factoring is simply another kind of invoice financing. While there are many other forms of financing that could be placed under the umbrella term invoice financing, it is usually used to refer to either invoice factoring, or invoice discounting. The primary difference between these two types of invoice financing is who collects the money that the customer owes.

With invoice factoring, the lender buys the customer’s debt from the borrower, which can reduce the risk of the customer not paying his debt, and also cut back the administrative cost of collecting the debt. That being said, invoice factoring limits the borrower’s ability to show customer loyalty, and his ability to be discreet about his financial situation. While with invoice discounting the borrower uses the invoice as collateral to secure a loan. This gives the borrower control over the invoice, but puts them at risk if the customer never pays their debt.

This change in structure also alters the credit requirements and the repayment schedule of the two types of loans.