What is Factoring?

Factoring goes by many names, including invoice discounting, receivables factoring and debtor financing. In simple terms, factoring is a practice wherein one company purchases a debt or invoice from another company. It refers to the acquisition of accounts receivable, which are discounted in order to allow the buyer to make a profit upon collection of monies owed. Factoring transfers ownership of such accounts to another party that then works vigorously to collect the debt.

While factoring may allow the liable party to be relieved of the debt for less than the full amount, it is generally designed to be more beneficial to the factor, or new owner, and the seller of the account than to the debtor. The seller receives working capital, while the buyer is able to make a profit by buying the account for substantially less than what it is worth and then collecting on it. Factoring allows a buyer to purchase such accounts for about 25% less than what they are actually worth.

The factor takes full responsibility for collecting the debt. The factor is required to pay additional fees, usually a small percentage, once collection efforts prove successful. The new owner of the account may offer the liable person or entity a small discount on the outstanding debt. Other arrangements are sometimes made, in which the debt is considered paid in full if a lump sum payoff is made under certain terms and conditions. Unfortunately, in some cases, factoring can cause the consumer or indebted company a great deal of financial stress, such as in the case of debt consolidation.

For example, if a person joins a debt consolidation program and one creditor engages in factoring, then the entity that purchases the account may not be bound by the program's contract with the original creditor. The factor may demand a large sum to consider the account current, and may increase interest rates as well as the monthly payment amount. This form of factoring may prove profitable in some cases, but in others it may backfire. The debtor may have no choice but to file for bankruptcy because he or she simply cannot afford the inflated interest rates and payment amounts. In the majority of cases, factoring is a profitable venture, but it is a good idea to review each account on an individual basis before deciding how to proceed.