Line of Credit (Bank Line)
A line of credit is a type of loan agreement between a bank and a borrower. Basically, a line of credit states that a borrower can borrow funds from the bank at will, up to a certain limit and within a specified period of time. During the specified time period and within the limitations of the allowable amount, the borrower may borrow and repay funds at the borrower’s discretion. When the line of credit expires, the borrower must repay all borrowed funds as well as any unpaid interest.
A bank charges interest on the borrowed money, charges a fee for the unused portion of the loan, and requires a collateral deposit from the borrower. A line of credit typically has a maturity of a year, though there are contracts with longer maturities, called revolving lines of credit, and contracts with no maturities at all, called evergreen credit. A line of credit is also referred to as a bank line.
Line of Credit Interest
Banks charge interest on lines of credit. The interest rate charged depends on the borrower’s creditworthiness and risk of default. The interest rate on a bank line is often a benchmark rate, such as a Treasury bill rate or another market based rate, plus a premium. For example, the interest rate might be the rate on two year Treasuries plus 1%. Different borrowers with differing degrees of creditworthiness will be charged various interest rates on lines of credit.
Line of Credit – Other Requirements
Banks typically require the borrower to maintain a compensating balance. A compensating balance is a percent of the value of the bank line that must be maintained as a deposit at the bank. For example, if the line of credit goes up to $100,000, and the compensating balance is 10%, then the borrower must maintain a deposit at the bank of at least $10,000. This compensating balance serves as collateral.
Banks often charge a commitment fee to borrowers for reserving the unused portion of the line of credit. For example, if the line of credit goes up to $100,000, and the borrower has borrowed $60,000, then $40,000 is left on the balance of the loan. The borrower may be required to pay a commitment fee, of perhaps 0.5%, on the $40,000 that is not being utilized. This fee represents the cost of keeping that amount available to the borrower, or committing the money to the borrower, so that it may be accessed as needed.
Line of Credit vs Loan
There are several advantages to using a line of credit. First, a line of credit is flexible. It allows the borrower to take out loans as needed and repay them when convenient, within the limits of the contract. Second, the borrower only pays interest on the portion of the loan that is used, and does not pay interest on the unused portion. However, the borrower may have to pay a commitment fee on the unused portion of the loan. Also, using a line of credit can reduce the paperwork and administrative tasks involved with taking out loans.