A loan commitment is a loan from a commercial bank or other lending institution that may be drawn down and contractually funded in the future. An open-end loan commitment acts like a revolving credit line, whereby if a portion of the loan is paid off, the principal repayment amount is added back to the allowable loan limit by the lender. The aggregate loan commitments of financial institutions registered in the United States must be disclosed on quarterly financial reports to regulators at the Federal Deposit Insurance Corporation (FDIC), which pays close attention to the institutions’ revolving credit lines.
A secured open-end loan commitment is typically based on the borrower’s credit worthiness and has collateral backing it. A home equity line of credit (HELOC) or a secured credit card are two examples. Because the credit limit is typically based on the value of the secured asset, the limit is often higher, interest rate lower and payback time greater than for an unsecured loan commitment. However, the approval process typically requires more paperwork and takes longer than with an unsecured loan. The lender holds the collateral’s deed or title or places a lien on the asset until the loan is completely paid. Defaulting on a secured open-end loan commitment may result in the lender assuming ownership of and selling the secured asset, using the proceeds to cover the loan.
An unsecured open-end loan commitment is primarily based on the borrower’s credit worthiness and does not have collateral backing it. An unsecured credit card is one example. Typically, the higher the borrower’s credit score, the higher the credit limit. However, the interest rate may be higher than on a secured loan commitment because no collateral is backing the debt. Unsecured loans typically have a fixed minimum payment schedule and interest rate. The process often takes less paperwork and approval time than a secured loan commitment.
Pros and Cons of Open-End Loan Commitments
Open-end loan commitments are flexible and may help fund unexpected short-term debt obligations. Also, HELOCs typically have low interest rates, making payments affordable. In addition, secured credit cards help consumers establish or rebuild their credit. Making timely payments and keeping credit card debt low help improve consumers’ credit scores. In time, consumers may receive unsecured credit cards, freeing up the secured credit card’s bank reserves for other spending options.
Example of a Loan Commitment
In July 2016, Scorpio Tankers Inc. (STNG) received a loan commitment up to $ 300 million to refinance existing debt of 16 multifaceted reflector product tankers. The loan’s maturity date was set for five years from the first draw down date and had an interest rate at the London Interbank Offered Rate (LIBOR) plus a margin of 2.5% per annum. The loan was made up of a term loan up to $ 200 million and a revolving loan up to $ 100 million. The loan’s availability may finance up to 60% of the fair market value of the vessels.