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Updated: Apr 10, 2020
Small business term loans and invoice factoring are two forms of financing available to business owners who need extra money. However, they’re structured very differently and commonly used to address different types of funding gaps.
Understanding and using the right type of funding can be an important part of making sure your company’s finances stay in order. Here, we’ll discuss how term loans and invoice factoring differ and when one might make more sense than the other.
Term loans, or installment loans, are a common type of personal and business financing. Anyone who has had a student loan, auto loan, or mortgage, has taken out a term loan.
The name — term loan or installment loan — describes how you’ll repay the money. When you take out a loan, the lender will send you the entire loan amount upfront. You’ll then repay it over a specific period, or term. And, you’ll do so with regular loan payments or installments. These may be weekly, bi-weekly, or monthly depending on the loan arrangements.
Small businesses can apply for term loans from various types of creditors, including banks and online lenders. You’re often free to use the money for (almost) anything, and several common use-cases include:
Depending on the lender and the loan’s terms (meaning the fine print, not the repayment period), you may be able to get approved and receive the funds within a couple of business days.
Your loan amount and interest rate will often depend on your creditworthiness and your business’ finances. Some lenders also charge origination fees when they disburse a loan and prepayment penalties if businesses want to repay the loan early.
Invoice factoring is also a relatively old form of financing that’s solely used in the business world. This is because factoring involves selling your business’ outstanding invoices to a factoring company — or simply called a factor.
You may have a client that places large orders but pays on net-60 or net-90 terms. Meanwhile, you run into a cash flow crunch because you need to pay for supplies right away, plus make payroll while the invoice is outstanding.
When you sell your invoice to a factor, the factor will often give you a percentage of the invoice amount upfront — often around 70 to 90 percent. After your client pays its invoice, the factor will send you the remainder of the money minus a fee for its service.
You may need to set up a new bank account or mailing address that the factor owns and tell your clients to send your payment there. Depending on the factor and arrangement, you may be able to do this without disclosing to your client that it’s now paying a factor rather than your business.
The factor’s fee, also called a discount rate or factoring rate, can depend on your business, industry, and your client’s creditworthiness, and generally ranges from 0.5% to 5%. For example, with a 5% factor rate on a $1,000 invoice, you may wind up paying $50 every 30 days the invoice goes unpaid. Some factors charge a lower rate but use a daily or weekly basis. Or, the factor may simply charge a flat fee regardless of the timing.
Factors can also charge additional fees, though. And some factors require you factor every invoice while others allow you to pick and choose which invoices to factors (called spot factoring). Generally, you’ll have a credit line that limits how much you can factor at a time, but you may also be charged a fee on the unused portion of that credit line.
|Business Term Loans||Invoice Factoring|
|Loan Amount||Ranges from several thousand to over $1M.||Depends on your outstanding invoices and the credit limit from the factor.|
|Payments||You’ll begin repaying the loan with regular (often monthly) payments.||The factor will take its financing fee out of your invoiced amount.|
|Repayment Period||You may be able to repay your loan over six months to several years.||The longer your client takes to pay their invoice, the more fees the factor could collect.|
|Annual Percentage Rate (APR)||Creditors often offer fixed-rate loans, with APRs of 5% to 35%.||Factor rates often range from 0.5% to 6% of the invoice amount every 30 days.|
|Requirements||Qualifying for a term loan can depend on your creditworthiness, revenue, and time in business.||Qualifying can depend on your business, personal, and clients’ credit. Also, you may have to run B2B business.|
|Additional Costs||You could have to pay origination, application, or administrative fees. Lenders may also charge prepayment and late payment fees.||In addition to factoring fees, you may have to pay application, maintenance, processing, wire transfer, lockbox fees, minimum, and early terminations fees.|
|Liability||Term loans may be secured or unsecured. Business owners may need to sign a personal guarantee.||If you sign a recourse factoring agreement, you may be responsible for unpaid invoices.|
When you’re comparing business financing options, you’ll want to consider what problem you’re trying to address and what type of financing will work best.
Term loans can be great when you want to make a large purchase, but you don’t want to take out a new term loan every month to make payroll. Conversely, you don’t want to rely on invoice factoring when purchasing an expensive, long-term asset, as you won’t be able to borrow more than a part of your accounts receivable.
As term loans and invoice factoring address different problems, you may find that using both types of financing can make sense at the time.
For example, you may want to take out a term loan to expand your business. But you also know that after the expansion, cash flow will be tight as your payroll and cost of goods increase. Even if your clients are buying more, they won’t necessarily be paying sooner. Having an invoice factoring relationship in place can help ease your cash flow concerns as you work through the transition.
Many creditors offer small business term loans, including banks, credit unions, and online lenders. Each may have different requirements, loan offers, and fees, and you may want to compare lenders and their offers before taking out a loan.
To narrow in on potential good-fit lenders, consider their ranges for loan amounts, repayment terms, fees, and interest rates. Also, look into the funding time, as some traditional banks may take weeks or months to review your loan application while an online lender may be able to give you a decision in minutes.