Late Payment Fees vs. Early Payment Discounts: Which Should You Choose?

The battle against late payments is a struggle that accounts receivable teams know all too well. Despite the economy showing signs of recovery, this challenge remains prevalent as customers continue to cling onto cash.

According to Atradius, 55% of all B2B invoices are overdue and bad debt affects 9% of all B2B sales.

As organisations search for strategies to combat this trend, they may turn to incentives or penalties that encourage faster payment. The question is — which of these will improve your customers’ payment behavior?

In this blog, you'll learn:

Methods for charging late payment fees
Pros and cons of late payment fees
Methods for charging early payment discounts
Pros and cons of early payment discounts
Are late payment fees and early payment discounts right for my business

Charging late payment fees

A late payment fee is a penalty that customers incur for paying invoices past their due date. There are several methods that finance departments use to charge customers.

One method is to charge interest based on the invoice total. A typical amount is between 1-2% for each month that the invoice is late.

As an example, a £500 invoice at 2% interest would incur a £10 fee after 30 days.

In more extreme cases, you might decide to charge compound interest, which means charging interest on the interest accrued as well. In the above example of a £500 invoice, you might charge 2% compound interest each day. After one month, the total amount owed would be £510. And after one month and one day, that amount would be £510.20.

Another option is to charge a flat rate fee for every week or month that the invoice is late. For instance, you could decide to charge the customer £25 a month. In this scenario, it's helpful to set the flat rate based on the size of the invoice. That means you might charge £25 a month for invoices under £500, or £40 for invoices over £500.

In each of these cases, it’s important to be aware of your local usury laws, which may limit the amount you can charge in late fees or interest. It’s also important to ensure that any potential penalties or fees are clearly stated in your customer credit agreement, as well as in dunning communications. In addition, the penalty information should be clearly stated on the invoice as part of your payment terms.

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Pros and cons of charging late fees

When determining whether to employ late fees, there are several factors to consider.

The benefits of a late fee policy include:

Faster payments – The threat of penalties can act as an incentive for your customers to pay their invoices promptly, reducing the frequency of late payments.
Compensation for lost time – Time and resources spent pursuing late payments have a cost. Late fees can help repay your organisation for that wasted time, as well as offset the financial stress incurred because of the late payment.
Better cash flow management – By discouraging late payments, you provide your organisation with a more consistent and dependable cash flow, making it easier to manage financial planning.

However, there are also risks associated with late fees. These can include:

Strained relationships – At a time when customer experience is often the difference between keeping and losing an account, late fees can potentially cause customer churn. This is especially true if the penalties and terms are more severe than those of your competition.
Administrative complexity – Adding fees and penalties means more work for your finance team, adding a layer of complexity to the process that can lead to errors.
Legal restrictions – Depending on your location, there may be specific guidelines for what you can and can’t do in terms of financial penalties. Failure to adhere to these regulations can have legal repercussions for your organization.

Implementing early payment discounts

As the name implies, an early payment discount is an incentive that allows customers to pay less than the full amount of an invoice in exchange for making payment in advance of required payment terms. For instance, a company may offer a 2% discount if invoices are paid within 10 days, instead of the 30 days stated within their credit terms.

That means if a customer with a £500 invoice chose to make their payment within 10 days, they would only pay £490. This type of incentive is referred to as a static discount as it offers the customer a predetermined amount off their invoice total.

You could also decide to offer a sliding scale discount, which adjusts the discount based on when the invoice is paid. That means the longer it takes a customer to pay, the lower the discount they’ll receive.

To illustrate, let’s refer to the £500 invoice example introduced above. In this case, your company might offer a 2% discount if it’s paid at the time of purchase, decreasing by 0.4% every six days. So, day 10 would have a 1.33% discount, day 15 would have 1%, and day 20 would have 0.67%.

Finally, there are dynamic discounts, which are discounts negotiated between the buyer and seller. In these cases, the customer may request a 2% discount on their £500 invoice. Your company might agree to the request but stipulate that payment must be made within 10 days of your customer receiving their invoice to earn the discount.

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Pros and cons of early payment discounts

As with charging a late payment fee, there are benefits and drawbacks to offering early payment discounts. When it comes to the benefits, companies can gain:

Quicker payments – Nothing motivates quite like cash, so giving customers the opportunity to put money back in their pockets is a powerful incentive.
Stronger cash flow – Faster payments mean stronger cash flow, which can fuel important activities like growth initiatives.
Increased customer loyalty – Offering more payment options and rewards is a sure-fire way to set you apart from the competition.

However, when considering offering early payment discounts, it’s also worth keeping in mind that it can lead to:

Less money per order – Offering a discount means taking less money per order. Depending on your existing profit margins, this may even result in you incurring losses on orders.
Discounts given to customers who already pay early – Some of your customers may already be paying early. In that case, rewarding them with a discount for pre-existing behavior serves no real purpose.
Extra work – As is the case with late payment penalties, offering an early payment discount will create additional work for your finance team. When judging the cost/benefit of a potential discount program, it's worth considering if your team has capacity for the added work.

Should I choose late payment fees or early payment discounts?

Ultimately, choosing late payment fees or early payment discounts will come down to your business’s individual needs. To determine which is best for you, it's helpful to look at external factors, such as whether your competition offers one or the other. You should also consider factors such as your existing profit margins and your company’s specific goals. For example, if your business prioritizes customer experience and retention, offering discounts will make more sense than penalties.