What is a Loan Commitment?
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. 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.
How a Loan Commitment Works
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, such as a home in the case of individual consumers. 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.
Obtaining a secured loan commitment – interest rates may be lower –requires putting up collateral, which you could lose if you can't repay the loan.
Types of Loan Commitments
Loan commitments can be either secured or unsecured. They have some key differences.
Secured Loan Commitment
A secured commitment is typically based on the borrower’s creditworthiness with some form of collateral backing it. On the consumer level, a home equity line of credit (HELOC), in which the equity in a home is used as collateral, or a secured credit card, where money in a bank account serves as collateral, are two examples of open-end secured loan commitments.
Because the credit limit is typically based on the value of the secured asset, the limit is often higher, the loan’s interest rate lower and the payback time longer for a secured loan commitment than for an unsecured one. 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 loan may result in the lender assuming ownership of and selling the secured asset, then using the proceeds to cover the loan.
Unsecured Loan Commitment
A loan that doesn't have collateral backing it is primarily based on the borrower’s creditworthiness . An unsecured credit card is one very basic example of an unsecured open-end loan commitment. 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 Loan Commitments
Having a loan commitment can be useful to consumers looking to buy a home or businesses planning to make a major purchase.
Open-end loan commitments are flexible and can be useful for paying unexpected short-term debt obligations or covering financial emergencies. In addition, HELOCs typically have low interest rates, making payments affordable, while secured credit cards can help consumers establish or rebuild their credit; paying their bill on time and keeping total credit card debt low will improve their credit scores, and in time they may be eligible for an unsecured credit card.
The downside of a secured loan commitment is that borrowers who take out too much money and are unable to repay the loan may have to forfeit their collateral, which could, for example, mean losing their home.
Unsecured commitments mean a higher interest rate, making borrowing more expensive.