Invoice factoring works by letting you sell your unpaid business invoices to a financing company, called a factor, for most of their value in cash right away. Instead of waiting 30 to 90 days for customers to pay, you get an advance within about a day, and the factor collects the full amount directly from your customer. Because the invoices are sold rather than pledged, factoring is not a loan and does not add debt to your balance sheet. The factor makes its money by keeping a percentage of each invoice as a fee before returning the balance to you.
The Two-Payment Cycle
Every factored invoice moves through the same rhythm. You deliver the goods or finish the services, issue the invoice, and submit it to the factor. The factor reviews it and wires you an advance, typically 70% to 90% of the face value depending on your industry and your customer’s payment record. That money usually lands in your account within 24 hours.
At the same time, the factor sends new payment instructions to your customer, directing them to pay into a lockbox or account the factor controls. Your customer pays the full invoice amount there on the normal due date. Once the factor has the money, it subtracts its fee from the withheld portion and releases the rest to you. That second payment is often called the reserve or rebate.
A concrete example: you submit a $10,000 invoice with an 85% advance rate. The next day, $8,500 hits your account. Thirty days later your customer pays the factor $10,000. The factor deducts a 2% fee ($200) from the $1,500 reserve and sends you the remaining $1,300. Your cost for a month of accelerated cash flow was $200.
What Factoring Actually Costs
The main charge is the discount rate, sometimes called the factor fee. It usually runs 1% to 4% per 30-day period. If your customer pays in 30 days, you pay one cycle. If they take 60, the fee roughly doubles. Some factors quote a flat fee that applies no matter when payment arrives, but that flat rate is priced higher to account for the uncertainty.
Several ancillary charges can quietly raise your effective cost:
- Wire transfer fees of $15 to $50 per transaction for same-day funding instead of standard ACH.
- Credit check fees of $5 to $10 each time the factor evaluates a new customer.
- Monthly minimum fees when your factored volume falls short of the contractual floor, ranging from $500 to $5,000.
- Account maintenance or lockbox fees, which can add 2% to 5% annually on top of the discount rate.
Ask any factor for the total effective cost annualized. A 2% monthly discount rate compounds to roughly 24% a year, and factors rarely present the number that way on their own.
Recourse vs. Non-Recourse: Who Absorbs a Bad Debt
This is the single most important term in a factoring agreement, because it decides who takes the loss if your customer never pays.
Under a recourse agreement, you do. If your customer fails to pay within the agreed window, the factor can require you to buy the invoice back or replace it with another of equal value. The factor’s risk is lower, so recourse contracts come with lower fees and higher advance rates. Most factoring contracts in the market are recourse.
Under non-recourse factoring, the factor absorbs the credit loss on approved invoices. If your customer becomes insolvent or files bankruptcy, you keep the advance. Because the factor cannot push the loss back to you, it charges more, advances less, and underwrites your customers more strictly.
Read the fine print. Many contracts sold as non-recourse only cover a narrow set of scenarios, usually customer bankruptcy, and exclude slow payment or billing disputes. If your customer withholds payment over a quality complaint, you may still owe the factor under a nominally non-recourse deal.
Spot Factoring vs. Contract Factoring
Contract factoring is the standard model. You commit to factor all, or a significant share, of your receivables over a set term, often 12 months. In exchange the factor offers better rates and higher advances. The tradeoff is inflexibility: monthly minimums, a locked-in term, and early termination fees if you want out.
Spot factoring lets you sell individual invoices with no long-term commitment. You choose which invoices and when. This suits businesses with seasonal cash gaps or those trying factoring for the first time. It costs noticeably more per invoice because the factor cannot spread its fixed costs across a guaranteed volume.
If your factoring volume is consistent, contract pricing almost always wins. If you only need occasional help on specific large invoices, spot factoring avoids the commitment.
Who Qualifies
Factoring companies care more about your customers’ creditworthiness than your own. They are buying your customers’ obligations to pay, so that is where the underwriting focuses. Personal credit matters far less than in bank lending, and some factors accept business owners with scores as low as 500.
Beyond customer credit, eligibility usually turns on a few requirements:
- Invoices must be business-to-business or business-to-government. Consumer receivables are almost universally excluded.
- The work must be complete. Progress billings common in construction are often ineligible because they represent partially completed work.
- Receivables must be clean, with no active disputes or history of chronic slow payment on that account.
- No other lender can hold a prior lien on your receivables. Existing liens have to be released or subordinated first.
- Your contract with the customer must allow assignment of payment rights. Under the Uniform Commercial Code, most anti-assignment clauses are unenforceable against a security interest in receivables, but some factors avoid the friction and decline restrictive contracts.
One thing will stop an application cold: an outstanding federal tax lien against your business. When the IRS files a Notice of Federal Tax Lien, it claims virtually all of your property, including receivables, and its priority can outrank the factor’s. Factors run lien searches before onboarding and periodically after. If a tax lien turns up, most factors stop funding immediately.1Internal Revenue Service. IRM 5.17.2 Federal Tax Liens
Setup: UCC-1 Filing and Notice of Assignment
Before funding starts, the factor files a UCC-1 financing statement with the appropriate state authority. This public filing tells other creditors that the factor has a legal claim to your accounts receivable. A financing statement must include your name, the factor’s name, and a description of the collateral.2Legal Information Institute. Uniform Commercial Code 9-502 – Contents of Financing Statement Filing fees vary by state, generally $10 to $100.
Priority among competing claims to the same collateral goes to whoever filed or perfected first.3Legal Information Institute. Uniform Commercial Code 9-322 – Priorities Among Conflicting Security Interests in Same Collateral If you later apply for a bank line of credit secured by receivables, the bank will see the factor’s UCC-1 and know those assets are already claimed.
The factor also sends a Notice of Assignment to each customer whose invoices are being factored. The notice tells them payment rights have been transferred and directs them to pay the factor going forward. Once your customer receives proper notice, paying you directly no longer satisfies the debt. They have to pay the factor.
Expect one more step at onboarding: invoice verification. The factor will contact your customer directly to confirm the goods were delivered, the services performed, and no disputes exist. It protects the factor from fraud and you from factoring an invoice that is heading for a fight.
Contract Terms Worth Reading Twice
Factoring agreements contain provisions that can trap you if you skim past them. Three deserve a slow read.
Monthly Minimums
Many contracts require you to factor a minimum dollar amount each month. In slow months, you pay the minimum fee whether you needed cash or not. Ask whether a version without minimums exists, or negotiate a floor that matches your lowest expected month.
Term Length and Auto-Renewal
Standard terms run 12 months and often auto-renew unless you send written notice 30 to 60 days before the renewal date. Miss the window and you are locked in for another year. Put the notice deadline on your calendar and confirm whether email is enough or the factor requires a mailed letter.
Early Termination Fees
Leaving early usually triggers a termination fee. Some contracts also carry guaranteed fee provisions: if the factor expected to earn a certain amount over the term, you owe the shortfall when you exit. If you switch factors, the new company handles the buyout by paying off the old advance and accrued fees, and may charge 1% to 1.5% of the buyout amount to manage the transition.
Tax Treatment of the Fees
Factoring fees, including the discount rate, administrative charges, and wire costs, are generally deductible as ordinary and necessary business expenses.4Office of the Law Revision Counsel. 26 USC 162 – Trade or Business Expenses The IRS treats factoring as a sale of receivables, and the fees paid to the factor are a cost of doing business. Businesses typically deduct them directly or net them against gross receipts.5Internal Revenue Service. Factoring of Receivables Audit Technique Guide
Because factoring is a purchase rather than a loan, the discount fee is not classified as interest. It is a discount on the sale of an asset. The distinction rarely matters for a straightforward domestic arrangement, but it can matter if the factor is a related foreign entity, where transfer pricing rules apply. Talk to a tax advisor before filing if your arrangement crosses borders.
Factoring vs. Invoice Financing
The two sound interchangeable and are not. With factoring, you sell the invoice outright. The factor owns it, contacts your customer, and collects. Your customer knows a third party is involved because they receive the Notice of Assignment and pay the lockbox.
With invoice financing, sometimes called an invoice line of credit, you borrow against your receivables but keep them. You still collect from your customers, and they never learn a lender is in the picture. The arrangement is confidential, but it creates a debt on your balance sheet, and lenders usually want stronger credit from your business because they cannot rely on your customer’s creditworthiness the way a factor can.
The right pick depends on what you value more: keeping customer relationships undisturbed, which points to invoice financing, or offloading collections entirely, which points to factoring. For businesses with thin credit histories and strong customers, factoring is often the easier path to approval.