Loan Commitment

Updated on March 19, 2024
Article byJyotsna Suthar
Edited byJyotsna Suthar
Reviewed byDheeraj Vaidya, CFA, FRM

What Is A Loan Commitment?

A loan commitment, or mortgage commitment, is an agreement letter where the lender, i.e., a commercial bank or financial institution, agrees to lend a certain amount to a business or an individual. Consumers who want to purchase a home or businesses preparing to make a significant purchase benefit from a loan commitment. The prime purpose of this agreement is to avail easy access to loans to make bigger purchases.

Loan Commitment

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Four types of loan commitments exist in the market. These commitments help the borrower to pay unexpected debts and expenses. Also, they provide flexible loan payments to the borrower. In addition, it improves their credit score. However, this agreement comes with an expiration and loan commitment fee.

Key Takeaways

  • A loan commitment, or commitment letter, is an agreement issued by the lender promising to lend money to an individual or business. It authorizes the borrower to access the mortgage facility.
  • The agreement’s contents include loan type, parties involved, expiration date, loan amount, terms and conditions, cancellation policy, interest rate, and others.
  • The six types involve revolving, non-revolving, secured, unsecured, conditional, and standby commitments.
  • The commitment fee typically ranges from 0.25 to 1%, and the duration of this letter expires after 30 days.

Loan Commitment Explained

Loan commitment letters are promissory notes allowing individuals to access a certain amount. Thus, financial institutions like banks promise to pay a specific sum to them. It acts like a payment commitment in place of collateral in the future. In addition, it also requires borrowers to pay commitment fees at the end.

When a financial institution commits to a loan, they do so based on the borrower’s creditworthiness and—if the loan is secured—the value of some collateral. For private consumers, this collateral can be a house. Then, up to the predetermined limit, borrowers may use the cash available under the loan agreement. Like a revolving line of credit, an open-end loan commitment operates as follows: A percentage of the loan’s principal that the borrower repays increases the lending limit access to the lender.

Mortgage loan commitments are subject to several requirements. As this agreement specifies, the loan amount, duration, and conditions differ. So, if they can fulfill them, the lender will issue the loan for a specific term; otherwise, they will not. Typically, the duration of the mortgage loan commitment is 30 days. However, it can vary depending on the lender’s processing time. On the amount, the lenders will charge a loan commitment fee of 0.25% to 1%. Taking the new loan amount and multiplying it by the commitment rate results in this fee.

The borrower can use this letter to access the third party’s line of credit (LOC). Since the party gets assured about their credibility, they get easy availability of assets. For example, a person who wants to lease an asset can use the commitment letter as proof. The leaser will check the individual’s current credit score and credit history. Thus, they can easily access the asset for their use.

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Types

Let us look at the types of loan commitments to understand the concept better:

#1 – Revolving Commitment

Also known as open-end commitment, it is a facility where the borrower can reuse the loan proceeds after paying the principal. For example, a person can use a credit card, make payments, and use the card again.

#2 – Non-revolving Commitment 

Also called a close-end commitment, the borrower can avail of the loan facility only once. Some examples include student loans, automobile loans, and other personal loans.

#3 – Secured Commitment

A secured commitment is a loan where a borrower can access loans only by keeping collateral. Or else it is not possible to avail of the mortgage facility. Likewise, the lender might seize the asset if they fail to pay it back.

#4 – Unsecured Commitment

It is the opposite of a secured commitment where no collateral is needed. Some examples include student loans where the lender asks for no collateral.

#5 – Conditional Loan Commitment

A conditional loan commitment is a facility where a lender will give a loan only if the borrower fulfills certain conditions. However, if they fail to do so, the lender might seize the property or keep the collateral.

#6 – Standby Loan Commitment 

A standby loan commitment or firm commitment lending is an agreement where the lender will process the loan only if other forms of financing become unavailable. For example, when an IPO (Initial Public Offering) needs more subscriptions, an investment bank usually buys the remaining shares.

Example

Let us look at the example of a loan commitment to understand the concept better.

Suppose Alex wants to buy an asset for which he applied for a loan at a nearby bank. However, there were some hurdles due to which the loan could not proceed. Later, the bank asked them to submit and fill out certain documents for fast approval. These documents included submitting the credit report, financial documents like tax returns, and proof of ownership. After submitting all the documents, the lender authorizes this commitment. As a result, Alex can use this letter to purchase the machinery for his business.

However, if the commitment expires, the lender is not obliged to lend money to the borrower. Thus, the borrower needs to renegotiate the terms and access the loan.

Letter Sample

Before assigning a loan to a person, the lender will put forth an agreement in the form of a letter detailing all the terms and conditions of the commitment. So, first, let us look at the contents of the commitment sample to comprehend the concept better:

  1. Loan amount
  2. Type of loan
  3. Address of the lender and recipient
  4. Repayment terms and conditions
  5. Expiration date
  6. Interest rate
  7. Commitment or attorney fees
  8. Collateral
  9. Cancellation policies
  10. Parties involved (guarantors, lender, administrative agent, and borrower)
  11. Other terms

Loan Commitment vs Pre-Approval

Although loan commitment and pre-approval are a part of the loan process, they differ slightly. The former is an agreement that promises to lend money. In contrast, the latter is a pre-verification that qualifies an individual for a loan. The former authorizes the loan facility to the borrower, while the latter will verify the financial documents and credibility before approving the loan.

BasisLoan CommitmentPre-Approval 
Meaning An agreement where a lender promises to lend money to the borrower.Pre-approval is when the lender asks for documents before approving the loan. 
PurposeTo approve and give easy access to loans.To assess the documents before approving loans. 
OccurrenceA week or before closing Conducted after submitting the purchase agreement.
Parties involvedLender and borrower Mortgage lending officer 
Contents Loan amount, type, parties involved, terms and conditions. Tax returns, financial statements, credit reports, and others. 

Frequently Asked Questions (FAQs)

1. How long does it take to get a loan commitment letter?

It takes 20 to 45 days to get the commitment letter. However, the process might vary depending on the lender. For example, some lenders might take time if the borrower submits the documents early.

2. Are loan commitment fees tax deductible?

Yes, they are deductible as per Federal law. As per the judiciary, the amount is tax deductible under section 162 (a), subject to capitalization rules. So, the amount is deductible if the line of credit is untouched.

3. What are unfunded loan commitments?

It is a commitment that allows lenders to supply additional funds to the borrower apart from the loan. It allows the latter to access extra capital for their purchases.

4. Is the loan commitment fee refundable?

It depends on the terms stated in the agreement. So, if the terms have stated the refund, the borrower might get the fee amount stated.

This article has been a guide to what is Loan Commitment. Here, we explain it in detail with its types, example, letter sample, and comparison with pre-approval. You may also find some useful articles here –

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