What Is Invoice Factoring? How It Works, Costs and Risks

Invoice factoring is when a business sells its unpaid invoices to a third party (a factoring company, or "factor") at a discount, in exchange for most of the money now instead of waiting for customers to pay. The factor then collects payment from your customers.

It's common in industries with long payment terms and thin cash buffers: trucking and freight, staffing, manufacturing, wholesale, and contractors working for large companies.

How it works, step by step

1. You deliver goods or services and invoice your customer as usual (say, $10,000 on Net 60).
2. You sell the invoice to a factor.
3. The factor advances you a percentage, often 70–90%. Here, $8,500.
4. Your customer pays the factor, not you, when the invoice is due.
5. The factor pays you the remaining balance ($1,500), minus its fee.

If the fee is 3% of the invoice, you'd receive $1,200 at the end. Total received: $9,700 for a $10,000 invoice.

What it costs

Factoring fees are usually quoted as a percentage per period, for example "2% for the first 30 days, then 1% per additional 15 days." Typical ranges are roughly 1–5% of the invoice value per month, depending on your industry, your customers' creditworthiness, your volume and the contract terms. Watch for extras:

• Application, setup or due diligence fees
• Minimum monthly volume requirements
• Per-invoice processing fees
• Bank transfer fees
• Early termination fees on long contracts

Always convert the total cost into an annual percentage. A "3% fee" on an invoice paid in 30 days is roughly 36% a year. That can still be worth it (for example, if it lets you take a profitable contract you otherwise couldn't), but it's expensive money.

Recourse vs non-recourse

• Recourse factoring: if your customer doesn't pay, you have to buy the invoice back or replace it. Cheaper, and more common.
• Non-recourse factoring: the factor absorbs the loss if the customer can't pay because of insolvency. More expensive, and the protection is often narrower than it sounds (it usually doesn't cover disputes).

Notification vs confidential

In most factoring, your customers are told to pay the factor. Some businesses worry this signals financial trouble; in industries like trucking it's routine and nobody blinks. Confidential or "undisclosed" arrangements exist but tend to cost more and require a stronger track record. If confidentiality matters, look at invoice financing, which usually leaves collection with you.

Factoring vs invoice financing

	Factoring	Invoice financing (discounting)
Invoices	Sold to the factor	Used as collateral for a loan
Who collects	The factor	You
Customer aware?	Usually	Usually not
Cost	Generally higher	Generally lower
Credit control help	Yes	No

When factoring makes sense

• You have creditworthy business customers who pay slowly (factors care more about your customers' credit than yours)
• Cash flow, not profitability, is the problem
• You have a specific use for the cash that earns more than the fee: payroll, taking a larger contract, buying stock at a discount
• You'd benefit from outsourced collections

When it doesn't

• Your margins are thin: a 3–5% fee may wipe out the profit on the job
• Your customers are consumers (most factors only buy B2B invoices)
• The underlying problem is customers who don't pay at all
• You could solve it more cheaply: deposits, shorter payment terms, early payment discounts or better follow-up

Questions to ask a factoring company

• What's the advance rate, and the fee structure in full?
• Is it recourse or non-recourse, and exactly what does non-recourse cover?
• Is there a minimum volume or a minimum term?
• Can I choose which invoices and customers to factor ("spot factoring"), or must I factor everything?
• What are the termination terms and fees?
• How will you contact my customers, and how do you handle disputes?

Factoring is a legitimate tool, but it's a financial contract with real costs. Read the agreement in full, and consider getting an accountant or advisor to look at it with you.