How Factoring Works

A lending company engages in different financial strategies to cope with the current demands of the market. There are instances when business plan need to be changed, directly affecting the contract it has with customers and other businesses. Sometimes, the money lent out need to be repossessed immediately to fund other investments or to stave off bankruptcy.

To avoid the risk of violating the contract, particularly the provisions covering the payment timeframe, the lending company makes a deal with another business institution. It sells the receivables or the financial asset associated with the borrower’s liabilities to hasten the recovery of the money involved in the loan. This process is called factoring, a term referring to the passing on of a lending contract to a new party.

Factoring involves three parties - the lending company who sells the receivables, the borrower who is liable for the receivables, and the third party who buys the receivables at a discount from the lender. The third party company is better known as the factor. What is passed on to the factor is the right to receive payment from the debtor according to the contract originally made. However, contract modification can be made between the new factor and the original borrower.

The factor faces several risks in this business. For example, a borrower may fail in its payment responsibilities as the original lending company defaults. It is a general accepted that credit card factoring transfers this risk to the factor once the deal is closed. It is the factor’s responsibility to create strategies to lessen the danger.

Credit card factoring is usually mistaken with invoice discounting. Both are procedures in finance that involves receivables and a third party. However, in invoice discounting, the receivable is not sold to the third party but is instead declared as collateral. This happens when the lending company enters into a separate agreement with another party and chooses to offer additional warranty.

Factoring is also different from a loan since the receivable is sold and all the rights over it is transferred to the buyer. All kinds of factoring, including credit card factoring, does not benefit the borrower but the seller. In fact, the borrower can be put at a disadvantage if the factor makes modifications to the contract.