Line of Credit Definition
A line of credit is an arrangement between the customer and a bank (or any other financial institution) where the customer is allowed a ceiling limit of borrowing and the borrower can access any amount within the credit limit and pays interest only on the amount borrowed providing high scale of flexibility to run a business.
The customer can withdraw any amount as per the needs within the preset limit and interest is charged only on the amount actually spent instead of the whole preset limit (also known as Sanctioned Limit). Furthermore, the customer can also schedule the repayment of the amount withdrawn either in lump sum or monthly installments as per their convenience with the Financial Institution at the time of sanction of such facility.
The Line of Credit for business is popular as it is a useful short-term financing instrument that helps them in meeting their working capital needs. It is also known as Revolving Credit. It is simply an access to money “on-demand”. The reason behind calling a LOC as revolving credit as it is basically a type of revolving account in which the customer can avail the funds within the preset limit, repay it and again avail it in a virtually never-ending revolving cycle.
However, usually, such arrangements are for a shorter period and are renewed periodically based on a satisfactory track record of the customer.
How Does Line of Credit works?
Under LOC, let say, Customer A is provided with $10000 LOC for the purchase of a home that is secured against the home by Baseline Bank. Baseline Bank set a loan term of 5 years for the repayment of the loan and allows Customer A, to use the funds within the overall limit ($10000) and charges an interest rate of 10%. Customer A spent $3000 and will be charged 10% of the amount spent only not on the entire $10000 LOC.
Further Baseline Bank has allowed Customer A to make payments on the Line of Credit either in the form of monthly installment on interest and principal or payment towards interest and payback principal at the end of the loan term.
Line of Credit Example – Walmart
Consolidated balance sheet of Wal-Mart as at 31st January 2017 & 2016
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source: WalMart 10K Report
We note from above that WalMart had a short-term borrowing of $1,099 million in 2017.
In their notes to accounts, they provided further details of their short-term borrowings as given below –
We note that Walmart had been committed line of credit for business with 23 financial institutions, totaling $15 billion as of 31st January 2017.
They had also mentioned in the note that they had extended both a five-year credit facility and a 364-day revolving credit facility in June 2016.
Types of Line of Credit
#1 – Secured Line of Credit
As the name suggests this types of Secured LOC are backed by collaterals and as such in the unlikely case of default, bank, and the financial institution can liquidate the same. A Secured Line of Credit is usually offered at lower rates of interest. A popular example of a secured Line of Credit is the Home equity line of credit (HELOC) which is backed by the collateral house property.
#2 – Unsecured Line of Credit
As the name suggests this type of LOC is not backed by any collaterals and as such are riskier for the bank and financial institution compared to a secured Line of Credit.
Unsecured Line of Credit is usually offered at rates of interest higher than the secured Line of Credit. A popular example of an unsecured Line of Credit is the Home equity LOC which is backed by the collateral house property.
- It allows the customer to withdraw money as and when required without the need of complying with loan formalities time and again. Further interest is charged only on the amount actually spent.
- The customer has the option to repay the amount spent either in lump sum or in installments depending upon their cash flow availability.
- Unsecured Line of Credit is usually charged a higher rate of interest and is a good source of higher interest income for banks and financial Institutions.
- The LOC is usually for a shorter period of time and allows the bank to review the creditworthiness of the customer whenever the renewal becomes due, unlike in the case of mortgage loans which are usually for a longer time frame and once committed are difficult to be withdrawn.
- Prepayment or part payment cost is comparatively less in the LOC compared to Mortgage loans.
- Unsecured Line of Credit is a costly short-term financing instrument for the customer.
- The LOC is usually for a shorter period and is not an appropriate instrument when funds are required for a longer time frame. The further LOC is usually linked with a variable interest which means interest charges are stated in terms of a short-term reference rate such as LIBOR or the U.S. prime rate plus a margin to compensate for the credit risk of the loan which keeps on changing and is not fixed.
Line of Credit is short-term funding provided by banks, in which the customer can borrow funds at any point in time up to the preset limit by ensuring compliance of terms and conditions as set out in the loan agreement.
Thus we can say that a Line of Credit is basically an account that the customer has with a bank or financial institution which allows them to borrow money whenever they need it up to a preset limit which is fixed based on the creditworthiness of the customer. Interest is charged only on the amount actually spent and once the amount spent is repaid, the credit line is again replenished up to the preset limit. Usually, the LOC is unsecured and as such attracts a higher rate of interest due to the inherent high amount of credit risk that the bank or financial institution undertakes.
Line of Credit turns out to be a handy financial instrument in cases when a customer requires funds on a regular basis but the amount may not be known upfront. It is also an indispensable source of financing for business as it helps them to manage the day to day running of the business and maintain liquidity for meeting the daily business cash flow requirements.
It is just like any other financial instrument is neither inherently good nor bad. It depends upon the usage of the customer in question. Since the interest rates are comparatively high and there is a heavy penalty for late payment, Line of Credit for business or customer should judiciously make use of the LOC facility and ensure timely payments.
This has been a guide to Line of Credit. Here we discuss how does Line of Credit for business works along with practical examples (Walmart), its types (secured and unsecured), advantages, and disadvantages. You may learn more about Corporate Finance from the following articles –