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What Is The Financial Definition Of Loan Commitment And How To Avail It

Understanding the financial definition of loan commitment is important to avoid confusion from the borrower’s end. At the same time, it is vital to ensure that as a borrower, you know your rights and the limitations of a loan commitment and that you fully recognize the responsibilities and obligations of both parties regarding the said agreement.

financial definition of commitment letter

In one way or another, you will need to get a loan one day.

You would probably get a loan to be able to buy yourself a new car, a house, or any major purchase you have been eyeing for, for the longest time.

But where do you get a loan?

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Well, there are a number of places where you can get a loan from. Financial institutions like banks, credit unions, as well as the growing number of online lenders, are everywhere. Once you have decided to borrow money, all you got to do is just decide where exactly to borrow money from.

Now, but before anything else. As a responsible and knowledgeable borrower you got to scout for the best loan options. You have to look for the best deal before you even seal it.

Once you have decided where to get a loan from, what normally happens is, a financial institution would give you a loan commitment, which basically states that the bank or the credit union or the lender is providing you with the amount you need and that the money is available anytime you need it.

Okay, we understand that the term “loan commitment” is kind of vague for some. As we kept saying, as a borrower, it is important to fully understand the whole concept.

So, having said that, we are going to share with you some of the most important details that every borrower should know about loan commitments – particularly the financial definition of loan commitment.

In particular, we are going to discuss the following items:

  • What is the financial definition of loan commitment?
  • What are the pros and cons of loan commitments?
  • What is the difference between a loan commitment letter and a pre-qualification letter?
  • What is the difference between secured and unsecured loan commitments?
  • How does revolving differ from non-revolving loan commitments?
  • What are the different examples of loan commitments?
  • How to get a loan commitment?

UNDERSTANDING THE FINANCIAL DEFINITION OF LOAN COMMITMENT

As a borrower, it is vital that you understand where you are putting yourself into especially when it comes to financial matters.

In this case, you have to fully understand the definition of loan commitment in order to ensure that you know how it exactly works (especially if it’s your first time).

According to Investopedia, a loan commitment, also known as a commitment letter, is defined as “an agreement by a commercial bank or other financial institution to lend a business or individual a specified sum of money.

The money borrowed can “take the form of a single lump sum or—in the case of an open-end loan commitment—a line of credit that the borrower can draw upon as needed, up to a predetermined limit.”

The document basically contains the lender’s promise to offer a loan or credit depending on the agreed amount to a borrower. The commitment comes with all the terms and conditions of the loan.

Generally, financial institutions base their loan commitments on the borrower’s creditworthiness (which is why when borrowing money, it is important that you have good credit to make approvals easier). In the case of a secured commitment though, financial institutions would look into the value of the collateral (which could be in the form of a car or a house for individual consumers).

Once a borrower has been handed a loan commitment, the borrower can then use the funds up to the agreed-upon limit to the purpose of securing the loan.

Meanwhile, in the case of an open-ended loan commitment, this basically works like a revolving line of credit wherein when a borrower pays back a part of the loan’s principal amount, the lender adds that amount back to the available loan limit, which the borrower can use up again (basically like a credit card in the form of a loan).

It is important to take note, however, that if you are given an open-ended loan commitment, it means you have met the lender’s qualifications, at the same time, you hit the required credit score.

Now, is a loan commitment legal and binding?

According to the American Bar Association, “a loan agreement is like any other contract: a binding agreement enforceable in accordance with its terms.”

This means that once a lender (whether it be a bank, or a credit union, or an online lender) has provided you with a loan commitment, it basically means they are already committed to giving you that money specified in the document.

But, wait! Can a borrower negotiate loan provisions before signing the commitment?

Sure, you can! That is precisely why we always encourage borrowers to scout and look around before sealing a loan deal — to ensure that both parties (lender and borrower) agree to all provisions, and not just one-sided.

Just keep in mind that once you got a loan commitment, you always have the last say. Meaning, it’s up to you if you will use that commitment or you will look for another. But, to save time and effort, and not mess up with a lender, it’s best to ask for quotations first and look around for reviews. That way, you do not waste each other’s time and effort, right?

If you want to know more about what a loan commitment is, check out below informative video by

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PROS AND CONS OF LOAN COMMITMENTS

Now that you already know the financial definition of loan commitment, and what the whole idea is all about, this time, we are going to share with you the some of the benefits and downsides of loan commitments.

Benefits

  • Loan commitments are useful to consumers who are planning to buy a car or a home, or any major purchases.
  • Open-ended loan commitments are flexible and can be used for paying unexpected short-term debt obligations, or in some cases, to cover financial emergencies.
  • Some loan commitments such as a home equity line of credit (HELOC) have low-interest rates.
  • Secured credit cards can help borrowers establish or rebuild good credit.

Downsides

  • For secured loan commitments, in case the borrower fails to pay off the loan, they may lose their collateral.
  • Unsecured loan commitments tens to have a higher interest rate.

DIFFERENCE BETWEEN LOAN COMMITMENT LETTERS AND PRE-QUALIFICATION LETTERS

Perhaps you have already heard of the term “pre-qualification” letter in the past especially if you have a check on loan options before.

A lot of people often confuse pre-qualification letter with a loan commitment letter and vice versa. But the thing is, these two are totally different from one another.

A loan commitment letter or also known as loan pre-approval basically contains the lender’s promise or commitment that the loan will be granted to you. It states that the lender is satisfied with the borrower’s loan application, they have conducted a credit history, and that the borrower’s credit score meets the requirements set by the lender. Furthermore, the letter says that the borrower has already gone through the necessary underwriting procedure, and they are ready to give the loan.

Meanwhile, a pre-qualification letter or also known as fliers that people usually receive in the mail from lenders seem to offer you financial products like loans or credit cards. The offer was made by doing a preliminary look at your finances, which may include your income, debt, as well as your assets. The letter is not tantamount to offering you a loan, rather, it basically is offering you the possibility of getting a loan, as well as the opportunity to borrow money from that financial institution.

Now, when you get a prequalification letter, do not easily get excited, and call the bank. Only make a call when necessary as these calls will show up on your credit report. Just so you know, having too many inquiries on your credit report is not good as it may appear as you are trying to get a lot of credit — even if in reality, you’re really not.

So, to be sure, just make a call when you badly need to make it. Right?

DIFFERENCE BETWEEN SECURED AND UNSECURED LOAN COMMITMENTS

Apart from understanding the financial definition of the loan commitment, it is also important to know that loan commitments have two types. These are secured and unsecured loan commitments.

Now, find out how the two differs below:

Secured Loan Commitments

A secured loan commitment is normally based on your creditworthiness as well as the presence of some form of collateral (could your house, car, or any asset you have) that will be backing up the loan. 

In the case of a home equity line of credit (HELOC) or a secured credit card, these two are referred to as open-ended secured loan commitments. This is because the credit limit is usually based on the value of the secured asset.

Now, since the credit limit on secured loan commitments is based on the value of the secured asset, borrowers would normally get to enjoy a higher limit, lower loan interest rate, and the payback time is longer.

The downside of unsecured loans though is that the approval process normally requires a lot of paperwork as compared to unsecured ones.

For secured loans, the lenders hold the collateral’s deed or title, or they place a lien on the asset until the loan has been paid off. But, in case the borrower defaults, it may cause the lender assuming ownership or selling the secured asset to cover the loan.

Unsecured Loan Commitments

Unlike secured loans, unsecured does not require any collateral to borrow money. Instead, it is primarily based on the borrower’s creditworthiness alone.

Normally, the rule of unsecured loans is that the higher the borrower’s credit score is, the higher the credit limit he or she gets.

However, since this is not backed by collateral, rates are usually higher as compared to secured loans. Also, they usually have a fixed minimum payment schedule as well as the interest rate.

Unsecured loans are ideal for those who want less paperwork and shorter approval time.

DIFFERENCE BETWEEN REVOLVING AND NON-REVOLVING LOAN COMMITMENTS

When planning to get a loan, it is very important to be familiar with the terminologies. It’s very important to avoid confusion in the future.

This time around, we are going to share with you the difference between a revolving loan commitment versus a non-revolving loan commitment.

Revolving Loan Commitment

Also called an open-ended loan commitment, a revolving commitment refers to a loan assurance given by a lender that guarantees the borrower the ability to use the funds from the loan not just once, but as long as payments are made on time.

Once the principal of the loan is paid off, the borrower can use the money again. The best example of this is credit cards.

Non-Revolving Loan Commitment

Meanwhile, a non-revolving credit or non-revolving loan commitment refers to a closed-end credit agreement, which means, you are only allowed to use the money once.

Once you have paid off the loan, the account is automatically closed. If you need funds, you will have to apply for a new loan.

Some common non-revolving loans include student loans, mortgage loans, and car loans.

DIFFERENT EXAMPLES OF LOAN COMMITMENTS

It is also important to know that loan commitments come in different types and vary a little per type of loan.

To give you an idea, see below examples of loan commitments:

  • Revolving Secured Loan – The best example for this one is a HELOC. You get approved of a certain amount, and for as long as you are paying off the principal amount, you can use the funds over and over. Just make sure though that you only use enough that you can pay off as secured loans mean your asset like your home becomes the collateral. Failure to pay off means losing your asset.
  • Revolving Unsecured Loan – The best example for this is a credit card loan. You are given a credit limit, which you can re-use sans the collateral. It’s not ideal for major purchases though, and usually, the interest rate is higher.
  • Non-Revolving Secured Loan – A home mortgage is the best example of this type of loan. It basically is secured by the property itself. Once the loan is paid off, the account is closed. Another example if auto loan — for the same reason and purpose.
  • Non-Revolving Unsecured Loan – Personal loan is the one that best fits this type of loan. You borrow money (which you can use for anything) from a financial institution without any collateral.

PROCESS OF GETTING A LOAN COMMITMENT

Now, you already know the financial definition of loan commitment plus all the other equally important information that go with, what’s next then?

Well, it’s time to familiarize yourself with the process of getting a loan commitment.

Having said that, below is a step-by-step guide on how you can get a loan commitment:

STEP 1: Review your credit history.

In order to get a loan commitment letter, you got to make sure that your credit history is free from errors. If there’s any, make sure to fix them first before you even apply for a loan.

You can get a copy of your credit history from three major credit bureaus, which are Equifax, Experian, and TransUnion. Review each to ensure that your credit history is error-free.

Take note that your credit history, as well as a high credit score, is key in order to get a loan commitment letter.

STEP 2: Fill out a loan application.

Depending on where you are applying for a loan, you could either fill out a loan application online or on-site.

As part of the application process, you will be asked to provide your personal information including your social security number, address, and birthdate.

Lenders may also require you to disclose the amount of your current income, debts, and assets (if applying for a secured loan).

STEP 3: Allow the lender to pull your credit report.

To be able to determine your risk level, lenders would use your credit score as well as your payment history, thus, the need for your permission.

By the way, before you fill out an application for the loan, make sure to compare loans from at least three different lending institutions. This will allow you to sign to the best possible rate and terms of the loan.

STEP 4: Provide your financial documents to the lender.

The requirements may differ from one financial institution to another, but, normally, they will ask you to provide them with your financial documents, which include payslips, W-2a or tax returns, as well as asset statements.

STEP 5: Receive a loan commitment letter.

Once you have done the steps prior to this, and your financial records are all good, then, you do not have to worry anything, because for sure, the bank or any financial institution for that matter will surely hand you a loan commitment letter.

FINAL THOUGHTS ON FINANCIAL DEFINITION OF LOAN COMMITMENT

A loan is a loan. It’s borrowed money.

While there are a lot of financial institutions out there that are willing to lend funds to those who need them, getting a loan is not an easy-breezy kind of thing. Meaning, there is a process.

Like when giving out a loan commitment, banks and other financial institutions make sure they only provide such to those who qualify based on their respective set of requirements.

A loan commitment, which basically refers to the lender’s commitment to providing the funds to the borrower serves as the borrower’s assurance. Once the borrower has it, it means, he or she can proceed to buy whatever the money is intended for.

So, having all this information, do you think you’ll pass getting a loan commitment yet?

Keep in mind the financial definition of loan commitment and the process of getting and you will surely have a breeze receiving one.