Line of credit

Last updated

A line of credit is a credit facility extended by a bank or other financial institution to a government, business or individual customer that enables the customer to draw on the facility when the customer needs funds. A financial institution makes available an amount of credit to a business or consumer during a specified period of time. [1]

Contents

A line of credit takes several forms, such as an overdraft limit, demand loan, special purpose, export packing credit, term loan, discounting, purchase of commercial bills, traditional revolving credit card account, etc. It is effectively a source of funds that can readily be tapped at the borrower's discretion. Interest is paid only on money actually withdrawn. Lines of credit can be secured by collateral, or may be unsecured.

Lines of credit are often extended by banks, financial institutions and other licensed consumer lenders to creditworthy customers (though certain special-purpose lines of credit may not have creditworthiness requirements) to address fluctuating cash flow needs of the customer. The maximum amount of funds a customer is allowed to draw from a line of credit is typically called the credit limit or overdraft limit. The term credit limit is commonly used for credit cards whereas the term overdraft limit is more commonly used for bank accounts.

Unsecured vs Secured LOCs

Most personal lines of credit are unsecured. This means the borrower does not promise the lender any collateral for taking an unsecured line of credit. One exception is home equity lines of credit (HELOC), which are secured by the equity in homes. [2]

Secured lines of credit offer the lender the right to seize the asset in case of non-payment.

Because their risk is lower, secured lines of credit typically come with a higher maximum credit limit and significantly lower interest rate. [3]

On the other hand, unsecured lines of credit have higher interest rates than secured lines of credit. A borrower must have a high credit score and good repayment history to meet the eligibility criteria for getting an unsecured line of credit. Since the unsecured credit line is not backed with collateral, if the borrower defaults on payments, the lenders cannot recover their losses. Hence, the lenders can minimize their risk by charging high-interest rates and restricting the credit line limit. [4]

Besides the HELOC, another relatively common form of secured LOC is the Securities Backed Line of Credit (SBLOC). [5] This is also commonly referred to as a Pledged Asset Line. [6] In this version, the borrower pledges securities (typically stocks, bonds, etc.) to the lender as collateral. The lender will typically lend less than the full value of the securities pledged, applying various "haircuts," depending on the lenders' assessment of how risky the pledged security is. For example, a lender might lend up to 80% of the value of a bond, but only 50% of the value of a stock. It's important to note that these LOCs are designated as non-purpose, meaning the proceeds cannot be used to purchase additional securities, unlike a margin loan. [7] Because of this, the loan to value ratios are typically higher than a margin loan, although, since the financial institution can set their own LTVs, this does not necessarily have to be the case. Depending on the LTV required, a borrower can sometimes use a margin loan to achieve the same objective as an SBLOC, since they can use the proceeds of their margin loan to purchase good and services other than securities. Borrowers, should be wary of these financial instruments, however, since they could be subject to a margin call, similar to what can happen with a margin loan, if the value of their pledged securities falls too low. Lenders also typically structure these LOCs as demand loans, meaning they have the right to demand full repayment of the loan at any time. [8]

Revolving vs close-end LOCs

A revolving line of credit allows a borrower to repeatedly draw money, up to their credit limit. It has a monthly payment and works similarly to a credit card.

A closed-end line of credit, on the other hand, has a fixed term. The term is divided into a draw period, where the borrower can draw money from the LOC as needed up to their credit limit, and a repayment period, where they can no longer draw money and are required to make monthly payments. [9]

Cash credit

A cash credit is a short-term cash loan to a customer. A bank provides this type of funding only after the required security is given to secure the loan. In cash credit, the bank advances a cash loan up to a specified limit to the customer against a bond or other security. Once a security for repayment has been given, the business that receives the loan can continuously draw from the bank up to a certain specified amount.

India

In India, banks offer cash credit accounts to businesses to finance their working capital requirements . These are usually to buy raw materials or current assets, as opposed to machinery or buildings (which would be called fixed assets). The cash credit account is similar to current accounts as it is a running account (i.e., payable on demand) with cheque book facility. But unlike ordinary current accounts, which are supposed to be overdrawn only occasionally, the cash credit account is supposed to be overdrawn almost continuously. The extent of overdrawing is limited to the cash credit limit that the bank sanctioned. This sanction is based on an assessment of the maximum working capital requirements of the organization, minus the margin. The organization finances the margin amount from its own funds.

Generally, a cash credit account is secured by a charge on the current assets (inventory) of the organization. The kind of charge created can be either pledge or hypothecation. [10]

Business line of credits

A business line of credit is quite similar to personal lines of credit. The financial institution grants access to a specific amount of financing. A business line of credit can be unsecured or secured (typically, by inventory, receivables or other collateral). Lines of credit are often referred to as revolving and can be tapped into repeatedly. For instance, if there is access to a $60,000 line of credit and $30,000 is taken out, access to the remaining $30,000, if necessary, remains. If all $30,000 is paid back, there is access to the entire $60,000 without having to reapply, one of the biggest benefits of a line of credit.

Costs and interest

The bank or financial institution will normally charge a fee for setting up a line of credit. [11] The fee would typically cover the cost of processing the application, performing security checks, legal fees, arranging collateral, registrations, besides other things.

Normally, no interest is payable under the line of credit until the customer actually draws on a part or all of the credit facility. There may also be a fee for keeping the credit facility open, which may be a monthly, quarterly or annual fee. This may be called an “unused line fee”, which often is an annualized percentage fee on the money not withdrawn. Credit card companies typically charge an “annual account fee”; they also typically apply complex interest charging rules, such as no interest being payable on purchases if the account is paid in full by the monthly due date, interest is payable on cash withdrawals from the day of such withdrawals, minimum monthly repayment amounts, etc.

Related Research Articles

<span class="mw-page-title-main">Loan</span> Lending of money

In finance, a loan is the transfer of money by one party to another with an agreement to pay it back. The recipient, or borrower, incurs a debt and is usually required to pay interest for the use of the money.

Credit risk is the possibility of losing a lender holds due to a risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased collection costs. The loss may be complete or partial. In an efficient market, higher levels of credit risk will be associated with higher borrowing costs. Because of this, measures of borrowing costs such as yield spreads can be used to infer credit risk levels based on assessments by market participants.

A repurchase agreement, also known as a repo, RP, or sale and repurchase agreement, is a form of short-term borrowing, mainly in government securities. The dealer sells the underlying security to investors and, by agreement between the two parties, buys them back shortly afterwards, usually the following day, at a slightly higher price.

A home equity line of credit, or HELOC, is a revolving type of secured loan in which the lender agrees to lend a maximum amount within an agreed period, where the collateral is the borrower's property. Because a home often is a consumer's most valuable asset, many homeowners use their HELOC for major purchases or projects, such as home improvements, education, property investment or medical bills, and choose not to use them for day-to-day expenses.

Asset-based lending is any kind of lending secured by an asset. This means, if the loan is not repaid, the asset is taken. In this sense, a mortgage is an example of an asset-based loan. More commonly however, the phrase is used to describe lending to business and large corporations using assets not normally used in other loans. Typically, the different types of asset-based loans include accounts receivable financing, inventory financing, equipment financing, or real estate financing. Asset-based lending in this more specific sense is possible only in certain countries whose legal systems allow borrowers to pledge such assets to lenders as collateral for loans.

Mezzanine capital is a type of financing that sits between senior debt and equity in a company's capital structure. It is typically used to fund growth, acquisitions, or buyouts. Technically, mezzanine capital can be either a debt or equity instrument with a repayment priority between senior debt and common stock equity. Mezzanine debt is subordinated debt that represents a claim on a company's assets which is senior only to that of the common shares and usually unsecured. Redeemable preferred stock equity, with warrants or conversion rights, is also a type of mezzanine financing.

In finance, unsecured debt refers to any type of debt or general obligation that is not protected by a guarantor, or collateralized by a lien on specific assets of the borrower in the case of a bankruptcy or liquidation or failure to meet the terms for repayment. Unsecured debts are sometimes called signature debt or personal loans. These differ from secured debt such as a mortgage, which is backed by a piece of real estate.

Hypothec, sometimes tacit hypothec, is a term used in civil law systems or to refer to a registered real security of a creditor over real estate, but under some jurisdictions it may additionally cover ships only, as opposed to other collaterals, including corporeal movables other than ships, securities or intangible assets such intellectual property rights, covered by a different type of right (pledge). Common law has two main equivalents to the term: mortgages and non-possessory lien.

<span class="mw-page-title-main">Second mortgage</span> Additional loan

Second mortgages, commonly referred to as junior liens, are loans secured by a property in addition to the primary mortgage. Depending on the time at which the second mortgage is originated, the loan can be structured as either a standalone second mortgage or piggyback second mortgage. Whilst a standalone second mortgage is opened subsequent to the primary loan, those with a piggyback loan structure are originated simultaneously with the primary mortgage. With regard to the method in which funds are withdrawn, second mortgages can be arranged as home equity loans or home equity lines of credit. Home equity loans are granted for the full amount at the time of loan origination in contrast to home equity lines of credit which permit the homeowner access to a predetermined amount which is repaid during the repayment period.

<span class="mw-page-title-main">Collateral (finance)</span> Borrowers pledge of property to a lender to be owed if a loan cant be repaid

In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan. The collateral serves as a lender's protection against a borrower's default and so can be used to offset the loan if the borrower fails to pay the principal and interest satisfactorily under the terms of the lending agreement.

<span class="mw-page-title-main">Credit</span> Financial term for the trust between parties in transactions with a deferred payment

Credit is the trust which allows one party to provide money or resources to another party wherein the second party does not reimburse the first party immediately, but promises either to repay or return those resources at a later date. The resources provided by the first party can be either property, fulfillment of promises, or performances. In other words, credit is a method of making reciprocity formal, legally enforceable, and extensible to a large group of unrelated people.

In finance, securities lending or stock lending refers to the lending of securities by one party to another.

A secured loan is a loan in which the borrower pledges some asset as collateral for the loan, which then becomes a secured debt owed to the creditor who gives the loan. The debt is thus secured against the collateral, and if the borrower defaults, the creditor takes possession of the asset used as collateral and may sell it to regain some or all of the amount originally loaned to the borrower. An example is the foreclosure of a home. From the creditor's perspective, that is a category of debt in which a lender has been granted a portion of the bundle of rights to specified property. If the sale of the collateral does not raise enough money to pay off the debt, the creditor can often obtain a deficiency judgment against the borrower for the remaining amount.

The vast majority of all second lien loans are senior secured obligations of the borrower. Second lien loans differ from both unsecured debt and subordinated debt.

A PIK, or payment in kind, is a type of high-risk loan or bond that allows borrowers to pay interest with additional debt, rather than cash. That makes it an expensive, high-risk financing instrument since the size of the debt may increase quickly, leaving lenders with big losses if the borrower is unable to pay back the loan.

A warehouse line of credit is a credit line used by mortgage bankers. It is a short-term revolving credit facility extended by a financial institution to a mortgage loan originator for the funding of mortgage loans.

Asset and liability management is the practice of managing financial risks that arise due to mismatches between the assets and liabilities as part of an investment strategy in financial accounting.

Collateral has been used for hundreds of years to provide security against the possibility of payment default by the opposing party in a trade. Collateral management began in the 1980s, with Bankers Trust and Salomon Brothers taking collateral against credit exposure. There were no legal standards, and most calculations were performed manually on spreadsheets. Collateralisation of derivatives exposures became widespread in the early 1990s. Standardisation began in 1994 via the first ISDA documentation.

The Enterprise Finance Guarantee (EFG) is a UK government-guaranteed lending scheme intended to help smaller viable businesses who may be struggling to secure finance, by facilitating bank loans of between £1,000 and £1 million.

A business loan is a loan specifically intended for business purposes. As with all loans, it involves the creation of a debt, which will be repaid with added interest. There are a number of different types of business loans, including bank loans, mezzanine financing, asset-based financing, invoice financing, microloans, business cash advances and cash flow loans.

References

  1. ↑ "What is Line Of Credit (LOC)?". Line Of Credit.
  2. ↑ Mayerle, Matt (2020-04-29). "Line of Credit". CreditNinja. Retrieved 2023-04-02.
  3. ↑ "Secured vs. Unsecured Lines of Credit: What's the Difference?". Investopedia. Retrieved 2023-04-02.
  4. ↑ "What is a Line of Credit & Why is it Useful?". 2020-11-02. Retrieved 2020-11-08.
  5. ↑ "SBLOC Securities Backed Line of Credit: The Definitive Guide". 22 October 2020.
  6. ↑ "The Pros and Cons of a Pledged Asset Mortgage or Loan".
  7. ↑ "Non-Purpose Loan".
  8. ↑ "Investor Alert: Securities-Backed Lines of Credit". SEC.gov. 2017-02-06. Retrieved 2022-08-30.
  9. ↑ "What is a personal line of credit? | finder.com". www.finder.com. 4 September 2019. Retrieved 2021-03-04.
  10. ↑ "Welcome to India in Business".
  11. ↑ R, Jessica (2024-04-22). "What is a Line of Credit?". ChoiceCash. Retrieved 2024-05-10.{{cite web}}: CS1 maint: url-status (link)
This page is based on this Wikipedia article
Text is available under the CC BY-SA 4.0 license; additional terms may apply.
Images, videos and audio are available under their respective licenses.