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 typically are 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.
- If you are taking out a mortgage loan, commitment fees may be wrapped into closing costs.
- The percentage of a commitment fee generally varies between 0.25% and 1%, according to the Corporate Finance Institute.
- Lenders use commitment fees to ensure they are compensated for guaranteed financial service.
- When a commitment fee occurs, it is for a future or undisbursed loan. Interest fees, like on a credit card, are calculated based on what a person has spent.
- The cost of a commitment fee will vary depending on the lender.
How a Commitment Fee Works
A commitment fee generally is 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. T
he 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.
In most cases, if the borrower decides not to move forward with the loan, the commitment fee still is payable to the lender.
Commitment Fee vs. Interest
Legally, a commitment fee is different from interest, although the two often are 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 also is charged, and paid, periodically. A commitment fee, on the other hand, often is 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 periodic commitment fee may be charged on the unused portion of the available funds.
Example of How to Calculate 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 periodic 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.