Term Loans Vs. Invoice Factoring: What's Best For Your Business?

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.

What is a small business term loan?

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:

• Purchasing a long-term asset: A loan can help you buy equipment, expand to a new location, or buy other long-term assets that will more than pay for themselves over time.
• Hiring an employee: When your business hits a tipping point and needs to hire a new employee, a term loan can give you capital for hiring, training, and buying extra supplies. 
• Expanding your business: You may need upfront funding to start a new marketing campaign or develop a new product line. 
• Refinancing debt: If you have high-rate credit card debt, you can use a low-rate business term loan to refinance the debt and save money on interest payments. 

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. 

What is invoice factoring?

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. 

How do term loans and invoice factoring compare?

Business Term LoansInvoice FactoringLoan AmountRanges from several thousand to over $1M.Depends on your outstanding invoices and the credit limit from the factor. PaymentsYou'll begin repaying the loan with regular (often monthly) payments.The factor will take its financing fee out of your invoiced amount. Repayment PeriodYou 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. RequirementsQualifying 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 CostsYou 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.    LiabilityTerm 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. 

What are the benefits and drawbacks of term loans?

Pros

• You get the entire loan amount upfront 
• Fixed-rate loans have predictable repayment amounts and periods
• You may be able to avoid many of the fees by choosing the right lender
• Creditworthy borrowers can often qualify for lower rates than they'd receive on other types of financing 

Cons

• You may need good to excellent credit to qualify for a low interest rate
• Term loans aren't great if you need to frequently borrow small amounts of money
• You have to watch out for lenders that charge a lot of fees
• Small business owners may need to put up collateral or sign a personal guarantee

What are the benefits and drawbacks of invoice factoring?

Pros

• Factoring can offer quick help during cash flow crunches
• You don't need good credit to qualify
• Makes it easier to work with big companies that generally pay on terms
• You often don't need to provide collateral 

Cons

• Can be an expensive form of financing
• Qualifying can depend on your clients' creditworthiness
• The terms can be restrictive and confusing 
• Sometimes, you may be on the hook for unpaid invoices 

When is it best to use a term loan or invoice factoring?

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.

Term loans are best when:

• You need a large loan: Creditors will determine your loan amount based on your business' creditworthiness and financial statements. Your personal credit and experience in the industry could also impact the decision. In general, a term loan may offer you the largest amount of funding compared to many other types of financing. 
• You want predictable payments: With a fixed-rate term loan, you'll know exactly how much you'll need to pay each month and when your payments will end. Also, you may be able to choose between different repayment periods, opting for a longer term with lower payments (but paying more interest overall), or a shorter term with higher payments. 
• You can save money: If you previously took out a high-rate loan or are paying credit card interest and can qualify for a lower-rate term loan, you may be able to save money. Refinancing or consolidating those debts can help free up extra cash and make your monthly payments more manageable. 
• You have an investment opportunity: Because you'll receive the entire loan right away, it's often best to hold off until you have a plan for the money. Whether that's buying supplies for a large order, hiring a new employee, or investing in another business location, consider your return on investment before taking out a loan. 
• You don't want to relinquish control: You may alternatively be able to raise funds with equity financing by selling partial ownership of your company. While equity financing can be useful at times, if you want to maintain complete control over your company, debt financing (such as taking out a term loan) is a better option. 

Invoice factoring is best when:

• You have cash flow problems: Being able to immediately receive payments on outstanding invoices can shore up your cash flow and keep your business running smoothly. But invoice factoring can also be expensive, and you generally shouldn't borrow money unless you need to or the extra funding will more than pay for itself. 
• You can't address cash flow issues another way: Sometimes, you may be able to address cash flow problems by negotiating shorter terms with your clients, or longer terms with your vendors. Or, you might incentivize clients to pay early by offering a discount. 
• You sell to other businesses: Invoice factoring generally only works when your customers are other businesses that pay on terms. If you run a supermarket or boutique, your patrons pay you right away anyway. If you have a manufacturing, distribution, staffing, or service company, you're more likely to send invoices and have to wait for payments. 
• You've reviewed the contract carefully: Although factoring is an old form of financing, you have to watch out for expensive and restrictive terms. For example, some factors have exclusivity contracts and require you to finance every invoice you send to a client-even if you don't need the money right away. Others may charge a variety of fees, and the arrangement could wind up offering short-term relief at the expense of your business' long-term success. 

How do term loans complement invoice factoring? 

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. 

What should you look for in a small business lender?

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.