What Is Invoice Factoring? How It Works, Costs & Alternatives

The 60-day gap that sinks profitable businesses

You invoice a client £18,000 for a completed project. Payment terms are net 60. Meanwhile payroll is due in two weeks, a supplier wants paying, and your own rent doesn't care that the money is "on its way." The work is done, the invoice is legitimate, and you are still short of cash.

Invoice factoring exists for exactly this gap. It lets you sell your unpaid invoices to a third party (a factor) for most of their value now, instead of waiting for the client to pay. You get cash fast; the factor takes a cut and, usually, the job of chasing the client.

It can be a lifeline. It can also be an expensive habit that quietly eats your margin. The trick is understanding precisely what you're paying for and whether a cheaper fix would solve the same problem.

How invoice factoring actually works

The mechanics are consistent across the US, UK, Canada, and Australia, even though providers dress them up differently.

1. You raise an invoice to a creditworthy business client on normal terms.
2. You sell that invoice to a factor. They advance you a percentage of the face value straight away, typically 70–90%. This is the "advance rate."
3. The factor collects payment from your client when the invoice falls due.
4. You get the rest, minus fees. Once the client pays, the factor releases the withheld balance (the "reserve") after deducting their charges.

A worked example makes the money flow obvious.

Say you factor a $20,000 invoice at an 85% advance rate with a 3% factoring fee:

• Advance paid to you upfront: $20,000 × 85% = $17,000
• Reserve held back: $3,000
• Factor's fee: $20,000 × 3% = $600
• When the client pays, you receive the reserve minus the fee: $3,000 − $600 = $2,400
• Total you receive: $17,000 + $2,400 = $19,400
• Cost of factoring that invoice: $600

You've effectively paid $600 to get most of $20,000 roughly 30–60 days early.

Recourse vs non-recourse

This distinction decides who eats the loss if the client never pays.

• Recourse factoring: if the client defaults, you buy the invoice back or repay the advance. Cheaper, because the factor carries less risk. Most factoring is recourse.
• Non-recourse factoring: the factor absorbs the loss if the client becomes insolvent. More expensive, and the protection is narrower than it sounds. Non-recourse often covers only genuine insolvency, not a client who simply disputes the work or drags their feet. Read the definition of a "credit event" in the contract before you assume you're covered.

Notified vs confidential

In most factoring arrangements, the factor contacts your client directly and payment is redirected to the factor. Your client knows. Some providers offer confidential factoring, where collection appears to still come from you, but expect to pay more for the discretion.

Factoring vs invoice financing: not the same thing

People use these terms interchangeably. They're different products with different risks.

Invoice factoring = you sell the invoices. The factor owns the debt and does the chasing. Your client typically deals with the factor.

Invoice financing (or invoice discounting) = you borrow against the invoices. You keep ownership, you keep collecting from your clients, and the lender advances you funds using the invoice book as security. It's a loan facility, not a sale.

Which suits you depends on control:

A one-person consultancy that hates chasing payments may prefer factoring. A £2m turnover agency with a proper finance function usually wants discounting, because it keeps client relationships in-house and stays confidential.

What it really costs

Factoring pricing is deliberately fiddly, which makes it hard to compare providers. Watch for these components:

• Discount/factoring fee: the headline charge, often 1–5% per invoice, sometimes quoted per 30 days outstanding. An invoice that pays late costs you more.
• Service or management fee: an ongoing charge, sometimes a percentage of turnover put through the facility.
• Setup and due-diligence fees: one-off charges to open the arrangement.
• Minimum monthly fees: you may be charged a floor even if you factor little that month.
• Facility fees, audit fees, and CHAPS/wire transfer charges: small individually, meaningful in aggregate.

Translate any quote into a real annualised cost. A 3% fee on a 30-day invoice looks small, but repeated every month it approaches 36% APR-equivalent on the advanced money. That's far higher than most business loans or credit lines. Factoring is priced like short-term convenience, not like cheap debt.

Watch the contract terms as much as the price:

• Whole-turnover clauses require you to factor all your invoices, not just the ones you choose.
• Long notice periods (12 months is common) lock you in even if you find something better.
• Minimum term commitments and early-exit fees.
• Concentration limits capping how much of your book can be one client.

When factoring makes sense, and when it doesn't

It can be a reasonable tool if:

• You sell to other businesses on credit terms (factoring rarely works for consumer invoices or paid-upfront work).
• Your clients are creditworthy but slow. Factors price on your clients' credit, not just yours, which can help newer businesses.
• You're growing faster than your cash allows and turning down work for lack of working capital.
• The margin on your work comfortably absorbs the fee. A 40% gross margin can survive a 3% factoring cost; a 6% margin cannot.

It's usually a poor fit if:

• Your invoices are small and numerous (fees and admin overwhelm the benefit).
• You bill consumers or do B2C work.
• Your margins are thin, so the fee erases your profit.
• The cash-flow problem is structural rather than timing-based. Factoring smooths timing; it can't fix a business that loses money on every job.

The real danger is dependency. Once your operating cash depends on the advance, stopping is painful, because you'd have to survive the gap while the facility unwinds. Some businesses stay factored for years and never claw back the margin.

Cheaper alternatives worth trying first

Before selling your receivables, work through the cheaper fixes. Several cost nothing but effort.

Get paid faster in the first place. A surprising share of the "cash gap" comes from slack invoicing habits, not genuinely slow clients. Invoice the day the work completes, not at month-end. Tighten your terms. See how to get invoices paid faster and rethink your payment terms — moving from net 60 to net 14 or net 30 may remove the problem entirely.

Take deposits and stage payments. Charging 30–50% upfront and billing milestones on longer projects shifts cash toward the start. Asking for a deposit is standard practice in most trades and services, and it costs you nothing.

Chase properly and early. A structured reminder sequence recovers far more than most people expect. Use payment reminder email templates and don't be shy about escalating when a client won't pay.

Offer an early-payment discount. Something like "2% off if paid within 10 days" (often written 2/10 net 30) can pull cash forward for a fraction of a factor's fee. If a client would otherwise pay in 45 days, 2% for 35 days early is far cheaper than 3% monthly factoring.

Charge late fees. Statutory or contractual interest gives slow payers a reason to prioritise you. Here's how to charge late fees on overdue invoices.

A business overdraft or line of credit. For businesses with a decent bank relationship, a revolving credit line is often cheaper than factoring and doesn't involve your clients at all.

A business credit card for short bridging gaps, if you clear it inside the interest-free window.

Run the numbers side by side. If a client pays in 40 days and you need the cash for 30 of them, compare the factoring fee against your overdraft interest for 30 days on the same amount. Factoring frequently loses that comparison badly.

Questions to ask any factor before signing

• What's the advance rate, and what triggers release of the reserve?
• Is it recourse or non-recourse, and exactly what does non-recourse cover?
• Is this whole-turnover or can I pick invoices (selective/spot factoring)?
• What's the all-in cost including service, minimum monthly, and transfer fees, expressed annually?
• What's the notice period and minimum term?
• Will you contact my clients, and how (notified vs confidential)?
• What happens if a client disputes an invoice?

If a provider won't give you a clear all-in figure, treat that as the answer.

Factoring is neither a scam nor a magic fix. It's expensive money that buys you time. Reach for it when the work is real, the clients are solid, your margin can carry the fee, and the cheaper levers above genuinely won't close the gap fast enough. For most freelancers and small firms, tightening terms and chasing harder solves the same problem without handing away 3% of every invoice.