Standby Line of Credit: Definition, Purposes, Examples

What Is a Standby Line of Credit?

A standby line of credit is a predetermined sum of money that a borrower can draw from as needed, either partially or in full. Businesses and individual consumers can use standby lines of credit for a variety of purposes.

How a Standby Line of Credit Works for Businesses

Standby lines of credit are often used by businesses. For example, a company might establish a standby line of credit with a financial institution if it needs to guarantee that it will pay a certain amount of money to a client if the business fails to perform its obligations under a contract.

In this situation, the standby line of credit would act as a kind of performance bond. The standby line of credit could be used as a backup source of funding in case the primary source fails. Financial institutions receive fees for establishing standby lines of credit.

Companies, not just financial institutions, may also offer standby lines of credit to other businesses. Such financing might be made available by a company, or companies, that own shares of the business that is seeking the line of credit. They may do this as a way to further support the growth and development of the business that they have an ownership interest in.

When multiple companies are involved, they can split up the burden and provide the business with an even larger line of credit to be used for whatever purposes are necessary. By contrast, a conventional lender might put restrictions on how the money can be used.

This type of standby line of credit might be arranged through a bank or investment broker, by setting up an account holding cash, money market funds, or publicly traded shares that would, in turn, serve as collateral for the standby line of credit. This would be considered a secured line of credit, although standby lines of credit may also be unsecured in some instances.

The terms of the standby line of credit agreement will include a schedule for the repayment of any funds drawn down by the borrower.

How a Standby Line of Credit Works for Individuals

Individual consumers can also make use of standby lines of credit.

For example, banks often offer a form of standby credit line to their depositors, agreeing to advance them a predetermined amount of money if they overdraw on their checking accounts. The amount might be from several hundred to several thousand dollars, and the customer typically won't pay any interest or fees for it unless they actually use it. This is often referred to as overdraft protection.

Federally insured home equity conversion mortgages (HECMs), the most common type of reverse mortgage, can have a standby line of credit provision, as well. The homeowner, who must be at least age 62, can borrow on the credit line as needed, paying the money back (with interest) only after they have moved permanently out of the home. (If they die, their heirs will need to pay off the loan, typically by selling the home.)

There are some upfront costs involved. "When the line of credit is opened," Wade D. Pfau, a professor at the American College of Financial Services, wrote in an analysis of HECM strategies, "the borrower will have to pay "a 0.5% upfront mortgage insurance premium payment (which ensures that the lender will be repaid in whole), origination fees, and other settlement costs. These fees can be paid in cash, or they can be borrowed from the line of credit."

After that, Pfau notes, the credit line will grow over time and may eventually exceed the value of the home itself. That's important because HECMs are non-recourse loans, meaning that the homeowner (or their heirs) will never owe more money than the home is worth, no matter how much they borrowed.

Consumers can also use their credit cards as standby lines of credit.

The Bottom Line

Standby lines of credit can be useful to both businesses and individual consumers, allowing them to borrow money when needed. While there are costs involved, a standby line of credit can be less expensive than borrowing (and paying interest on) more money than turns out to be necessary. It can also be faster than a regular loan because it has already been approved.