What is Invoice Factoring?
Invoice factoring is a type of financing where you sell a customer’s outstanding invoice at a discount to profit from the capital. The institution granting the invoice factoring will give you an advance, usually worth about 70% – 85% of the value of the invoice. Then, once it’s paid off, you’ll get the rest of the value minus a fee. Invoice factoring has a lot of administrative costs and is usually used by businesses that have large contracts with the government or other businesses that offset those costs.
Discount Rate (Factor Rate)
Sometimes there are fees for invoices that aren’t paid on time. In this case, an institution can charge you in two ways. The most common way is known as discount rate. The way a discount rate works is you’ll only ever be charge a factoring fee, except that it’ll start to increase after the payment term has passed, usually at a rate of 1% per week. The other way is known as the prime plus method, which basically consists of paying interest. You’ll pay a fixed rate (usually about a 12% APR) right from the beginning until the invoice is paid. Again, while 12% is a pretty high APR, in the long run this can be cheaper than a discount rate, depending on how long it takes for the invoice to be paid off.
Invoice Factoring vs Invoice Discounting
The main difference between invoice factoring and invoice discounting is who controls the invoices. When an invoice is factored the institution takes control of it. At this point, it becomes their responsibility to collect from the customer. When an invoice is discounted, on the other hand, it’s used as collateral, and stays in your control. Some borrowers prefer invoice discounting because it lets them collect from their own customers and keep their need for outside financing discrete. Since the invoice is repaid by the customer, the credit of the borrower doesn’t come into consideration, which is an advantage if you have bad credit. With invoice factoring, on the other hand, you pay at regular intervals, and take on the risk that the customer might fail to pay their invoice on time.
How Invoice Factoring Works
Invoice factoring can be a handy form of financing under the right circumstances. If you feel it’s a good option, it’s recommended you talk with an expert to best understand your own situation and determine the best way to keep your business running at its full potential.