Explaining the Difference Between Invoice Factoring and Bank Lending

When discussing invoice factoring with referral partners and prospective customers, the common inclination is to compare the cost of money through factoring to the cost of money through bank lending. However, these two processes are fundamentally different, making such a comparison challenging. Here’s a helpful way to explain the distinction:

Comparison to Early Payment Discount

A direct comparison for invoice factoring can be drawn with the early payment discounts offered by many companies to their customers. Typically, these discounts are stated as “2/10 Net 30,” meaning customers can deduct 2% from the invoice amount if they pay within 10 days. Otherwise, they must pay the full price within 30 days.

Invoice factoring essentially accomplishes the same goal as early payment discounts, but without offering customers the option to take the discount. There are advantages to this approach. Firstly, customers do not become accustomed to expecting a discount, which means that when a business no longer needs to factor its invoices, that 2% directly contributes to the bottom line.

Another benefit of factoring is that some customers may insist on taking the offered 2% discount but still delay payment until the 30-day deadline. This completely defeats the purpose of offering the discount. Factoring eliminates this issue.

Comparison to Accepting Credit Card Payment

At its core, invoice factoring allows business owners to collect immediate payment from customers who either cannot or prefer not to pay in cash. In the consumer world, this is achieved by accepting credit card payments, which entail merchant processing fees ranging from 1.75% to 4% of the transaction value, depending on factors such as card type, bank, and transaction volume.

For instance, Square, a company that enables credit card processing through mobile devices, charges a 2.75% fee per transaction. Invoice factoring operates on a similar transaction-based principle. Typically, the service fee for factoring an invoice ranges from 2% to 2.5%, making it a more cost-effective option compared to credit card payment fees.

Comparison to Bank Lending

The distinction between factoring and bank lending can be likened to the difference between buying and renting. Bank lending is akin to paying a rental fee. When a business borrows money or accesses funds from a line of credit, it must repay the borrowed amount in full along with additional interest. This is similar to renting a car, where you return the vehicle and pay for the privilege of using it. Likewise, with a bank loan, you have the privilege of using the bank’s money but must repay it and cover the associated interest.

In contrast, invoice factoring does not involve borrowing money. Instead, a business sells an asset, namely an invoice from its accounts receivable, to the factoring company. This asset requires the customer to fulfill their payment obligation. Thus, the factoring company recoups its investment when the customer settles the invoice.

Converting a discount rate (like the early payment discount mentioned earlier) into an interest rate involves a unique calculation. It is not as straightforward as multiplying the discount rate by 12 months, as the discount applies to revenue, not a static borrowed amount. On the other hand, an interest rate is applied to a specific borrowed sum.

For example, let’s assume a business sells $100,000 worth of invoices to a factoring company each month, with a discount rate of 2.5% per invoice (which is on the higher side). Over a year, $1,200,000 in future revenue would be factored, resulting in a cost of money of $30,000 (2.5% of $100,000, multiplied by 12).

To calculate the comparative cost for borrowed money, you would multiply the lender