A loan commitment is an agreement by a commercial bank or other financial institution to lend a business or individual a specified sum of money. A loan commitment is useful for consumers looking to buy a home or a business planning to make a major purchase.
The loan can take the form of a single lump sum or in the case of an open-end loan commitment a line of credit that the borrower can draw upon as needed (up to a predetermined limit).
Financial institutions make loan commitments based on the borrower’s creditworthiness and in if it’s a secured commitment on the value of some form of collateral. In the case of individual consumers, this collateral may be a home. Borrowers can then use the funds made available under the loan commitment, up to the agreed-upon limit. An open-end loan commitment works like a revolving line of credit: When the borrower pays back a portion of the loan’s principal, the lender adds that amount back to the available loan limit.
A loan commitment is a formal letter from a lender stating that the applicant has met all of the qualifications for receiving a loan, and that the lender promises a specific amount of money to the borrower.
Many loan commitments are open-ended, meaning the loan is not just a one-time, lump sum payment that the borrower must pay back. Instead, the borrower can continue to use this amount as long as he or she keeps paying it back. This makes it similar to a revolving line of credit, such as a credit card. If the borrower uses a portion of the loan amount and pays it back, the lender applies the payment to the borrower’s principal balance.
An open-ended loan commitment is contingent upon the borrower’s credit status and requires meeting certain qualifications. A loan commitment can be either secured or unsecured. An unsecured loan requires no collateral, but a secured loan does.
Un-funded lines of credit and their Characteristics
An unfunded line of credit is one that a bank issues to a borrower, but is not borrowed upon at the moment it is issued. The bank or lending institution will honor any future draws upon the unfunded line of credit, but does not need to make any money available until the moment the customer requests it.
Borrowers Of Unfunded Lines of Credit
Borrowers of unfunded lines of credit can be either individual retail customers or businesses. Businesses such as hedge funds and insurance companies are customers of unfunded lines of credit, and they most commonly use them as an emergency fund. Retail customers can also acquire unfunded lines of credit in the form of home equity lines. Unfunded loan commitments, whether to retail or corporate clients, represent liabilities to both borrowers and banks.
Risk Of Borrower Default
A borrower can default after drawing upon the line of credit, causing a major problem for the bank which acted as a lender. For example, if a major catastrophe happens which requires an insurance company to pay out claims for which it does not have sufficient cash reserves, that insurance company may draw upon its unfunded line of credit. If the insurance company is unable to pay back what it borrowed from the bank and files for bankruptcy, the bank must count the unrecovered money as a loss.
Risk Of Bank Default
Unfunded lines of credit pose major risks for banks. Because the bank must honour the line of credit at any given point in the future, it must have enough cash to do so. If a bank issues too many unfunded loan commitments, and a high number of them are unexpectedly drawn upon, the bank will be unable to honour the loan commitment. Banks are required to report unfunded lines of credit quarterly to the United States government’s Federal Deposit Insurance Corporation. Every bank limits the number of unfunded credit lines it will issue to mitigate liability.
Typically, unfunded commitments are separated into two categories:
Multiple Advance, Closed End: This type of loan (typically a construction loan) advances incremental amounts up to a certain limit, based upon some criteria such as inspection and approval of a draw request. Any principal reductions received during the loan period are not available to be drawn on, but rather have paid down the loan balance.
Revolving or Open End: This type of loan (known informally as a Line of credit) allows the borrower to continue to borrow up to the original loan amount. Principal reductions are immediately available for future advances.