Accounts receivable factoring is the sale of your unpaid customer invoices to a third-party company, called a factor, in exchange for immediate cash. The factor typically advances 80% to 95% of an invoice’s face value within a day or two, collects payment directly from your customer, and releases the balance to you minus a fee that usually runs 1% to 5% per month. Because you’re selling an asset you already own rather than borrowing against it, factoring doesn’t create debt on your balance sheet.
How the Transaction Works
Three parties are involved: you (the seller), the factor (the financing company), and your customer (who owes the invoice). The factor’s main concern is whether your customer will pay, not whether your own business has clean financials. That focus is what makes factoring accessible to newer or fast-growing businesses that can’t qualify for a bank loan.
The process starts after you deliver goods or services and issue an invoice. You submit that invoice to the factor. The factor reviews your customer’s payment history and financial stability, and if approved, wires you an initial advance of 80% to 95% of face value. The exact percentage depends on your industry, your customer’s credit profile, and how the contract is structured.
The factor holds the remaining 5% to 20% in a reserve account. Once your customer pays in full, the factor releases the reserve to you, minus the factoring fee. On a $50,000 invoice with a 90% advance ($45,000) and a 3% fee ($1,500), you’d receive another $3,500 when the invoice settles.
Your Customer Gets Notified
Most factoring arrangements require your customer to be told the invoice has been sold. Under the Uniform Commercial Code, once your customer receives proper notice that the invoice has been assigned, they’re legally required to pay the factor directly and can no longer satisfy the debt by paying you.1Legal Information Institute. UCC 9-406 – Discharge of Account Debtor; Notification of Assignment Your customer also has the right to request proof that the assignment actually happened before redirecting payment.
This is where some businesses hesitate. Having a third party collect on your invoices can shift how customers perceive your financial health. In industries like trucking, staffing, and manufacturing, factoring is common enough that most commercial customers are used to receiving payment redirection notices.
Recourse vs. Non-Recourse: Who Eats the Loss
The most important line in any factoring contract is who takes the loss when your customer doesn’t pay. This single provision determines whether you’re transferring real risk or just accelerating cash flow while keeping the downside.
In recourse factoring, you remain on the hook if your customer defaults. If the customer goes bankrupt or refuses to pay, you must buy the invoice back from the factor. Recourse arrangements are cheaper precisely because the factor isn’t absorbing credit risk. Most factoring contracts are recourse, and an unusually low fee quote usually reflects that.
Non-recourse factoring shifts the risk of your customer’s insolvency to the factor. If the customer genuinely cannot pay because of financial failure, the factor absorbs the loss. This is where most misunderstandings happen. “Non-recourse” almost never means the factor eats every kind of loss. It typically covers only credit risk, meaning the customer’s inability to pay. If your customer disputes the invoice over a quality issue, short-ships the order, or claims you didn’t deliver what was promised, you’re still responsible for resolving that dispute and likely repurchasing the invoice. Non-recourse costs more, and factors often require higher creditworthiness from your customers before approving these terms.
Spot Factoring vs. Whole-Ledger Contracts
How many invoices you commit matters almost as much as the fee structure.
Spot factoring, sometimes called single-invoice factoring, lets you sell individual invoices on an as-needed basis. You pick which invoices and when, with no obligation to submit your entire receivables portfolio. There’s usually no long-term contract. The trade-off is cost: spot rates run higher per invoice because the factor can’t count on predictable volume. It works well for businesses that occasionally need a cash flow bridge but don’t want an ongoing commitment.
Whole-ledger factoring, also called full-turn factoring, requires you to factor all eligible invoices, typically under a contract that runs 12 months or longer. In exchange, you’ll see lower discount rates, better advance percentages, and reduced per-transaction fees. The factor benefits from predictable volume and a diversified pool of customer credit risk. The downside is that you’re locked in, and exiting early can be expensive.
What Factoring Actually Costs
Factoring costs break into three components. The advance rate is the percentage you receive upfront, typically 80% to 95%. The reserve is the amount the factor holds back until your customer pays, usually 5% to 20%. The discount fee is what the factor charges for the service, deducted from the reserve when the invoice settles.
Discount fees are commonly quoted as a percentage per time period: 1% for every 10 days the invoice remains unpaid, or a flat 2% to 3% for a 30-day invoice. Many factors use tiered pricing where the rate climbs as the invoice ages. An invoice paid in 20 days might cost 2%, but a 60-day payment could push you to 5% or more.
The Annualized Number
Factoring fees look modest as monthly percentages and add up quickly on an annual basis. A 3% fee per 30 days on invoices that turn monthly translates to roughly 36% annualized. Even a lean 1.5% per month comes to about 18%. That’s significantly more than most bank lines of credit. Before signing, run this calculation against what a traditional loan or credit line would cost you. It’s ten minutes of math.
Fees Beyond the Discount Rate
The discount fee isn’t the only cost. Common additions include:
- Setup or application fees when the account is established.
- Wire transfer fees each time the factor sends you an advance, sometimes $25 to $50 per wire.
- Monthly minimums, where you pay a fee if your factored volume falls below a required dollar amount.
- Early termination fees on whole-ledger contracts, often 2% to 5% of annual factoring volume. On $100,000 monthly volume, a 2% early termination fee could mean $24,000 if you leave a year early.
Many factors also require a personal guarantee from the business owner, which puts your personal assets at risk if things go sideways. It’s standard in the industry but rarely the first thing a factor mentions in a sales pitch. Ask about it directly.
The UCC Filing and What It Locks Up
When you enter a factoring agreement, the factor will almost certainly file a UCC-1 financing statement with your state’s Secretary of State. This public filing puts other lenders on notice that the factor has a legal claim on specific assets of your business. Under the UCC, the sale of accounts receivable falls within the same legal framework that governs secured transactions, which is why the filing is necessary even though factoring is technically a sale rather than a loan.2Legal Information Institute. UCC 9-109 – Scope
The filing includes your business name, the factor’s name, and a description of the collateral being claimed.3Legal Information Institute. UCC 9-502 – Contents of Financing Statement That collateral description matters. A specific lien limited to your accounts receivable leaves your equipment, inventory, and other assets free for other financing. A blanket lien covering “all assets” ties up everything your business owns and can make it extremely difficult to get a bank loan, equipment financing, or any other credit while the filing remains active.
Before signing, confirm in writing whether the UCC-1 will cover only receivables or all business assets. If you already have an existing lender with a blanket lien, the factor will need to negotiate a subordination or intercreditor agreement before establishing priority over your receivables. Filing fees themselves are modest, generally $5 to $40 depending on the state, but the type of lien can shape your borrowing options for years.
Once you sell an invoice, you no longer have a legal or equitable interest in it. The UCC makes this explicit: a business that has sold an account does not retain any ownership rights in what was sold.4Legal Information Institute. UCC 9-318 – No Interest Retained in Right to Payment That Is Sold If your business later faces creditor claims or bankruptcy, sold receivables belong to the factor, not to your creditors. The flip side is that you can’t use already-factored invoices as collateral for other financing, and you can’t redirect the customer’s payment back to yourself once the assignment is in place.
How Factored Income Is Taxed
The IRS treats cash you receive from factoring as business income. You report the full invoice amount as revenue. For cash-method taxpayers, income is recognized when you actually or constructively receive it.5Internal Revenue Service. Publication 538 – Accounting Periods and Methods For accrual-method taxpayers, income recognition depends on when all events establishing your right to payment have occurred, which in most factoring arrangements means the date you invoice your customer.
The discount fee and other charges the factor deducts are deductible as ordinary business expenses. Keep detailed records of every invoice sold, the fees charged, and the dates. Your factor isn’t required to send you a 1099 for these transactions because they’re purchasing an asset, not paying you for services. The record-keeping burden falls entirely on you.
When Factoring Is the Right Tool
Factoring works best for businesses that sell to creditworthy commercial customers on 30-, 60-, or 90-day payment terms and need cash faster than those terms allow. Staffing agencies, trucking companies, manufacturers, and distributors are the heaviest users because they face large upfront costs like payroll, fuel, and raw materials while waiting weeks or months for payment. If your customers are financially solid but slow, factoring converts their good credit into your working capital.
It’s a poor fit when your profit margins are thin enough that the fees eat into your ability to operate. A business running on 5% net margins can’t absorb a 3% monthly factoring fee without going backward. It’s also problematic when your customer base is highly concentrated. Factors generally cap any single customer at around 20% of your total receivables, so if one client accounts for most of your invoicing, that client’s invoices may not be eligible in full. And if you qualify for a traditional line of credit, the math almost always favors the cheaper option. Factoring fills a real gap, but it’s expensive enough that most businesses should treat it as a stepping stone to cheaper capital rather than a permanent part of their financial structure.