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Term loans vs. Accounts Receivable Financing: What’s Best for Your Business?

Business Finance

Term loans vs. Accounts Receivable Financing: What’s Best for Your Business?

Updated: April 8th, 2020

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Business owners may turn to small business term loans and accounts receivable financing to address different funding needs. The former is often best for large, one-time purchases. The latter can help with cash flow and may be an option for businesses that have poor credit.

Neither financing option is particularly good or bad. It depends on the circumstances, your goals, and the terms that lenders offer. But knowing the differences between business term loans vs. invoice factoring and A/R financing and when you should aim to use one over the other could help you save money and efficiently run your business. 

What is a small business term loan?

A small business term loan is a type of loan that you can take out for almost anything. With a term loan, you’ll receive the loan amount upfront and repay it in regular installments over the lifetime of the loan — or the loan’s repayment “term.” 

Generally, lenders require you to make monthly payments, but you may have to repay some term loans with weekly or bi-weekly payments instead. Term loans can either be secured or unsecured.

  • Secured: A secured loan requires you to offer the lender collateral in exchange for accepting a loan. Auto loans, mortgages, and equipment loans are examples of secured term loans. Business loans may be secured with a lien on the business’ assets. 
  • Unsecured: Unsecured terms loans may have similar rates and repayment requirements, but you don’t need to offer the lender collateral. An unsecured loan can limit your risk, but it may be harder to qualify, and you may receive a higher interest rate. 

Because term loans allow you to borrow a large amount of money and slowly repay the loan, they’re often good fits for business owners who have a specific investment in mind and can handle the added expense

Buying equipment, hiring employees, investing in a new product, and purchasing supplies before a busy season are several common reasons you might want to take out a term loan. You may even benefit from using a term loan to refinance other, higher-rate debt. 

As with other types of loans, the lender, your business’ finances and creditworthiness, and the owner’s personal credit can impact your term loan offers. Compare lenders to determine which offers a term loan that will help your business reach its goals. 

What is accounts receivable financing?

With accounts receivable financing (A/R financing), you’ll use your accounts receivable as collateral for a loan or line of credit. In some cases, the arrangement may call for invoice financing or invoice discounting. It’s also a type of asset-based lending

A/R financing vs. invoice factoring

Accounts receivable financing can be similar to invoice factoring, and the terms are sometimes used interchangeably. However, there are two significant differences. One is that with invoice factoring, your clients will generally pay the factoring company directly. Meanwhile, with invoice financing, you’ll still collect payments from your clients and repay the lender. 

Second, some lenders of factoring loans only offer recourse factoring, This means you’ll be responsible for unpaid invoices even if you’re factoring rather than financing. However, there’s still a difference because, with invoice financing, the accounts receivable and the loan will be on your balance sheet. 

How accounts receivable financing works

With accounts receivable financing, you may be able to share a copy of your invoices or give the lender access to your accounting software for verification purposes. Depending on the lender, you could get a loan or line of credit for a portion (such as 70 to 90 percent, but sometimes up to 100 percent) of your outstanding accounts receivable. 

Once you take out a loan against your invoice, you start repaying the loan plus interest or fees weekly, bi-weekly, or monthly. The finance charge may be based on the total invoice amount and could be charged on a similar schedule. The longer you take to repay the loan, the more you’ll pay in fees or interest. 

Some accounts receivable financing agreements have an invoice factoring structure. In these cases, your clients may wind up paying off the factoring loan directly to your lender. You may have to agree to set up a new bank account that the lender controls and direct your clients to send invoice payments to the account. 

Accounts receivable financing can be a good option for rapidly growing business-to-business companies that often have to wait to get paid and have trouble keeping up with increasing cash-flow demands. It can also help young businesses, as qualifying for accounts receivable financing can depend on your customers’ credit more than your own. 

Business term loans vs. accounts receivable financing: How do the two compare?


Business Term LoansAccounts Receivable Financing
Loan AmountYou may be able to borrow several thousand dollars to $1M or more.Around 70 to 90 percent of your accounts receivable. 
PaymentsPayments start once you receive the loan.You may pay off the loan or line of credit directly, or have your client pay the creditor. 
Repayment PeriodYou may be able to choose a term. Options could range from several months to years.May be several weeks to years. 
Annual Percentage Rate (APR)Often a fixed interest rate with an APR of around 5% to 35%.Lenders may charge on the loan or line of credit. Or, you may pay a funding fee based on the loan amount and a daily or weekly rate.
RequirementsVaries by lender, but can often depend on the business’ creditworthiness, revenue, and time in business.  Lenders may review your customers’ creditworthiness. You may need to have a B2B business.
Additional CostsThere may be an origination, application, or administrative fee. Late payment fees are standard, and some lenders charge prepayment fees. Lenders may charge a variety of fees, such as application, maintenance, and processing fees.    
LiabilityYou may need to sign a personal guarantee and collateral to secure a term loan. You’re responsible for repaying the loan even if your client doesn’t pay its invoice.

What are the benefits and drawbacks of term loans?

Pros

  • Receive a potentially large loan amount right away
  • Get a fixed-rate and plan your payment amounts
  • Know how long it will take to pay off your loan and how much it will cost
  • May offer low-interest rates and monthly payments 

Cons

  • Can be harder to qualify for a low-rate loan than other types of financing 
  • You’ll need to take out a new loan each time you need additional funding 
  • Some lenders may charge lots of fees and interest 
  • Owners might have to sign a personal guarantee, and the business may need to put up collateral 

What are the benefits and drawbacks of accounts receivable financing?

Pros

  • Qualify based on your customers’ credit rather than your own
  • Get paid based on your outstanding invoices without offering collateral 
  • Potentially inexpensive compared to other fast funding options for new businesses or those with poor credit 
  • Take out multiple loans or credit line draws without reapplying 

Cons

  • Can be more expensive than long-term financing options 
  • Can be hard to qualify if your clients don’t have good credit 
  • The terms can be hard to understand or restrictive 
  • Won’t necessarily help with large projects

When is it best to use a business term loan vs. invoice factoring or accounts receivable financing?

As a business owner, it’s often up to you to find, compare, and determine which financing option is best. Many new companies turn to accounts receivable financing or invoice factoring when they’re growing and don’t have enough of a track record or credit history to qualify for financing on their own. A term loan can be a better option for making larger leaps.

Term loans are best when:

  • You need a lot of financing: Your term loan limits will depend on the lender, your creditworthiness, and your business’s finances, not your outstanding invoices. If you need to borrow a large amount of money, a term loan is often a good option. 
  • You have a specific project in mind: The structure of a term loan can make it a good fit for large projects. Perhaps you may want to purchase a retail store, hire a new employee, or redesign your website. These investments can pay off over time, and a term loan can help you get the funds you need to start. 
  • You want control over your payments: Lenders may offer you several different repayment terms and rates when you first take out a loan. Your monthly payment will depend on the loan offer you accept. If you can choose a fixed-rate loan, you’ll be able to predict your monthly payment and can plan accordingly. 
  • You currently have high-rate debt: If you can qualify for a low-rate term loan, you can use the funds to pay off higher-rate debts and save money. Consolidating credit card debt is often a good option, or you may be able to refinance previously taken out term loans with higher rates.

Accounts receivable financing is best when:

  • You have a short-term cash flow gap: If you have trouble covering all your bills while waiting to get paid, A/R financing can smooth out your cash flow by giving you immediate access to funding after you send an invoice. A short-term cash flow gap tends to be a problem for companies that are new, rapidly growing, or have substantial upfront costs for their products or services. 
  • You run a B2B company: If you generally sell directly to consumers, you may not have long terms on your invoices and likely won’t qualify for A/R financing. 
  • You want to retain ownership of the invoice: If you don’t feel strongly about owning the invoice, also consider invoice factoring and see which option can work best for your business. 
  • You’ve read over all the terms: A/R financing can go by many names and is often confused with invoice factoring. It can also be a complex form of financing with varying repayment terms, fees, and interest rates. Make sure you read over the contract carefully and understand all the terms before signing. 
  • You’re working on building credit: Businesses that are building credit can use A/R financing as a stepping stone until they can qualify for a term loan or line of credit.  

How do term loans complement A/R financing? 

Term loans are best suited for large, capital intensive projects that you want to slowly pay for over time. Meanwhile, A/R financing can help you quickly address short-term cash flow problems. Getting your business into a position where it can qualify for either type of financing allows you to match the financing type to the problem you’re facing. 

Perhaps you’ve grown to the point where you need to hire a new employee, but don’t have quite enough money to cover the cost of recruiting and training. A/R financing may be able to help, but a term loan could be a better fit as it allows you to cover all the costs with a minimal impact on the rest of your business’ finances. Then, as the new employee leads to larger orders, you may want to use A/R financing to help pay for supplies and payroll while you fulfill the orders. 

What should you look for in a small business lender?

You can apply for a business term loan at a bank, credit union, or non-bank lender. Some specialized online lenders focus on small business term loans and may offer an easier and quicker application and funding process than traditional lenders.  

The best option may depend on your needs and preferences. For example, a Small Business Administration loan may offer low rates, but it can also take weeks or months to get funding, and you may need to make a down payment. An online lender could get you funding within a couple of business days without any down payment and potentially fewer fees. 

As you compare lenders, make sure you meet their criteria, and they offer loans that align with your goals. Each lender may have different interest rate ranges, application processes, funding times, fees, and repayment terms. Use these to eliminate lenders that likely won’t work.  

Some lenders may also show you estimated loan offers with a quick application that doesn’t hurt your credit, which can be a good starting point. After comparing several estimates, you could go with the lender that offers you the most favorable loan. 

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