A Line of Credit is a pre-established amount of credit extended to a borrower by a lender that can be drawn upon as needed. Such loans are used to provide quick liquidity for acquisition or development of real estate, to leverage notes receivable, or other purposes subject to pre-approval by the lender.
Once the line is established, it works much like a check book for accessing capital. Usually, there are loan covenants that dictate how the borrower can use the Line of Credit, and the amount spent cannot exceed the credit limit.
Lines of credit may be “secured or unsecured”. Unsecured lines are supported merely by the borrowers guaranty of repayment (premised on net worth and liquidity) and are therefore more difficult and less common. “Secured lines look to specified collateral such as real estate, as a lending base. The line is constrained to a conservative percentage of the value of the collateral.
The most important advantage of a Line of Credit over a regular loan is that the borrower can draw on the Line at any time necessary and interest is only charged on the outstanding loan balance. Typically, there is a 1% annual fee for the credit facility.
The structure of the line is flexible and can be adjusted to the needs of both the borrower and the lender. Lines of credits are typically limited to 2 to 3 years.
Once the Line of Credit is exhausted, it cannot be drawn upon again until the principle is repaid. A “revolver” permits the borrower to drawdown and repay the line repeatedly over the term. This draw and repayment process may continue multiple times until the term of the Line of Credit expires or the credit limit is reached. A non-revolving line permits drawdown and repayment only once.
Line of Credit facilities are typically secured by a lien on the assets of the company, personal assets, or by real estate. Usually, real estate acquired through the use of the line will be pledged to the lender as additional collateral. Credit lines are typically full recourse to the borrowing entity and its principals.
Lines of Credit are extended to borrowers with a proven earnings track record, adequate financial ratios, and overall moderate credit risk.