known as “loan commitments,” in which the bank and the
borrower agree in advance that the latter can draw against the
credit line as needed up to some maximum limit. Within this
limit, the borrower decides on the timing and the amount of
the borrowings. In this way, lines of credit function much like
credit cards. The main advantage of such arrangements is their
flexibility, allowing the borrower who may need temporary financing
as it accumulates inventory to obtain the funds it
needs to operate, while then paying off the loan after sales
have occurred and cash has been collected from customers.
Bankers like these arrangements, too, because they take up
less of the loan officer’s time. Of course, before such financing
can be extended, a detailed analysis of the borrower’s creditworthiness
must be completed. The loan officer evaluates the
purpose of the credit line, the prospects for repayment, the
maximum amount that the bank is willing to lend, compensating
balance requirements (i.e., bank accounts that the borrower
is required to maintain), and the interest rate charged.
The line of credit can be secured (with specific assets pledged
against it) or unsecured; it can be fixed-rate or floating; and
the underlying note can be a demand note or fixed-term. But
in nearly all cases, the line of credit is short-term, often lasting
only 90 days. Although lines of credit are normally confirmed
in writing, the nature of the agreement is informal, with
bankers reserving the right to cancel or amend the agreement
at will. In addition, letters of confirmation typically state that
loans may not be available if the borrower’s financial condition
changes for the worse.
Read More : Short-Term Loans
