What is a 'Commitment Fee'
A commitment fee is a banking term used to describe a fee charged by a lender to a borrower to compensate the lender for its commitment to lend. Commitment fees are typically associated with unused credit lines or undisbursed loans. The lender is compensated for providing access to a potential loan through a commitment fee since it has set aside the funds for the borrower and cannot yet charge interest.
BREAKING DOWN 'Commitment Fee'A commitment fee is generally specified as either a flat fee or a fixed percentage of the undisbursed loan amount. The lender charges a commitment fee as compensation for keeping a line of credit open or to guarantee a loan at a specific date in the future. The borrower pays the fee in return for the assurance the lender will supply the loan funds at the specified future date and at the contracted interest rate, regardless of conditions in the financial and credit markets.
Legal Qualification of a Commitment Fee
Legally, a commitment fee is different from interest although the two are often confused. The key distinction between the two is that a commitment fee is calculated on the undisbursed loan amount while interest charges are calculated by applying an interest rate on the amount of the loan that has been disbursed and not yet repaid.
Interest is also charged, and paid, periodically. A commitment fee, on the other hand, is often paid as a one-time fee at the closing of the financing transaction. A further commitment fee may be charged by a lender at the renewal of credit facilities. In the case of open lines of credit, a periodical commitment fee may be charged on the unused portion of the available funds.
In most cases, if the borrower decides not to move forward with the loan, the commitment fee is still payable to the lender.
Calculating a Commitment Fee
In the case of a one-time loan, the commitment fee is negotiated between the lender and the borrower. The fee can be a flat amount, such as $1,000, or a percentage of the loan amount, such as 1%.
For an open line of credit, a formula is used to calculate the average available amount of credit on a periodical basis, often quarterly. The fee is then calculated by multiplying the average unused commitment by the agreed-upon commitment fee rate and again by the number of days in the reference period.