What Is a Loan Commitment?

Loan Commitments Explained

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Definition

A loan commitment is a letter promising a loan or credit by a commercial bank or other lending institution that may be made some time in the future, based on the terms of the loan contract.

Definition and Example of a Loan Commitment

A loan commitment generally is given to an individual or business in the form of a letter from a lending institution, which may be a commercial bank, mortgage bank, or credit union. The letter spells out the financial institution's promise to lend a certain amount under certain terms in the future. The loan has not yet been issued, but it is approved. A loan commitment letter differs from a prequalification letter.

  • Alternative Name: Loan pre-approval

A loan commitment letter, also called "loan pre-approval," actually promises that you can receive a loan. It promises that the lender is satisfied with your loan application and has checked your credit history and credit score. You have gone through any necessary underwriting procedure, and they are ready to make the loan to you.

For example, if you apply for a mortgage and are approved, you can shop for a home and make an offer. You'll often submit your loan commitment or pre-approval when you submit your purchase offer for the home.

How Loan Commitments Work

In order to get a loan commitment letter, the first thing you should do is review your credit history for any errors and fix them immediately. You can get copies of your credit history from the three major credit bureaus, and you should review each of them. You need a spotless credit history and a high credit score.

Compare similar loans from at least three different lending institutions for the best interest rate and terms. For a student loan, most universities have their applications online or direct you to the appropriate site. It is imperative that you apply for a student loan at least three months in advance of the start of the school term.

Loan commitments come in several different types and can vary slightly by the type of loan:

Revolving Secured Loan: One example is a home equity line of credit (HELOC). If you are approved for a HELOC, then you have a certain maximum loan amount, but as long as you make the payments on the loan, you can use the principal, pay it off, and use it again. Bear in mind that your home is the collateral for the loan.

Revolving Unsecured Loan: One example is a credit card loan. You will have a credit limit on your credit card. When you draw down part of your credit card limit by making a purchase, you can use it again after you pay it off. There is no collateral associated with a credit card.

Non-Revolving Secured Loan: One example is a home mortgage. It is secured by collateral, which is your home. When the home is paid off, the account is closed. The first mortgage on a home is a non-revolving secured loan. Another example is your automobile loan.

Non-Revolving Unsecured Loan: One example is a personal loan that you take out from a commercial bank for some reason, perhaps credit card consolidation. Another example is a student loan.

Types of Loan Commitments

Various types of loan commitments exist. They include:

Revolving Loan Commitment

A revolving loan commitment—also called an "open-ended loan commitment"—refers to a loan assurance that guarantees that the borrower can use the proceeds from the loan over and over if payments are made on time. As the principal of the loan is paid down, the borrower can use those funds again. One example of this is a credit card.

Non-Revolving Credit Agreement

Non-revolving credit is also called "closed-end credit," because it can only be used once. After it is used, the account is closed. Examples of this type of loan include student loans, mortgage loans, and automobile loans. Payments on closed-end credit accounts must still be made on time and according to the terms of the loan commitment letter.

Secured and Unsecured Loan Commitments

Both revolving and non-revolving loans can be either secured or unsecured. A secured loan commitments is backed by an asset that can be seized if the loan is not paid. This asset is called "collateral." Secured loan commitments are usually made in the case of mortgage loans and automobile loans. Unsecured loan commitments, like credit card loans and student loans, are not secured by collateral.

Loan Commitment vs. Prequalification Letter

While a loan commitment letter comes with the promise that you have qualified for a loan and will receive one, it is different from a prequalification letter.

Prequalification letters—unsolicited flyers you receive in the mail from lenders—seem to offer you loans or credit cards, but in these cases, the lenders have only taken a preliminary look at your finances. The lender may have looked at your income, debt, and assets, but it is not yet offering you a loan. They are only offering you the possibility of a loan and the opportunity to apply for one.

 Loan Commitment Prequalification Letter
Borrower applies for loan. Offer may come unsolicited.
Complete credit check performed. Preliminary look at borrowers finances.
Lender is prepared to fund the loan. A loan is not guaranteed.

Note

If you contact a credit card company after getting a prequalification letter, it will show up on your credit report as an inquiry.

Key Takeaways

  • A loan commitment is a letter issued by a lending institution, promising to make available sometime in the future a certain amount under certain terms.
  • Unlike a prequalification letter, a loan commitment means that the borrower has been approved for the loan.
  • Loan commitments may be made for secured or unsecured loans.
  • Terms may be revolving and reusable, or non-revolving one-time loan commitments.
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