Commitment fee: Overview, definition, and example
What is a commitment fee?
A commitment fee is a fee charged by a lender to a borrower for making a loan or credit facility available, even if the borrower does not fully draw on the loan or use the credit line. The fee compensates the lender for setting aside funds or reserving credit for the borrower’s use. Commitment fees are typically expressed as a percentage of the unused portion of the loan or credit line, and they are often included in credit agreements for revolving lines of credit, loans, or other financial arrangements.
For example, a bank may charge a 1% commitment fee on a $1 million credit line, meaning the borrower will owe a fee on the unused portion of the credit line each year.
Why is a commitment fee important?
A commitment fee is important because it provides compensation to the lender for reserving funds or credit capacity, which may otherwise have been used by other borrowers or investments. For lenders, the fee ensures that they receive some financial benefit from the agreement even if the borrower does not use the full credit line. For borrowers, the fee serves as a cost of having access to credit, even if they don’t use the full amount immediately.
For businesses, understanding commitment fees is essential for budgeting and financial planning, as these fees represent an ongoing cost that must be factored into the overall expense of borrowing or maintaining a credit facility.
Understanding commitment fees through an example
Imagine a company that has a $500,000 revolving line of credit with a bank. The company only uses $200,000 of the credit line, leaving $300,000 unused. The bank charges a 0.5% commitment fee on the unused portion of the credit line, so the company owes a fee of $1,500 annually (0.5% of $300,000) for having access to the full $500,000, even though it only used part of it.
In another example, a business secures a loan with a commitment fee of 1% on the unused portion of a $10 million credit line. If the business only draws $4 million from the facility, it will be required to pay the commitment fee on the remaining $6 million, which amounts to $60,000 annually.
An example of a commitment fee clause
Here’s how a commitment fee clause might look in a loan or credit agreement:
“The Borrower agrees to pay a commitment fee to the Lender equal to [Insert Percentage]% per annum on the unused portion of the credit facility. The commitment fee shall be payable quarterly in arrears, beginning on the first day of the month following the execution of this Agreement.”
Conclusion
Commitment fees are an important part of lending and credit arrangements, providing lenders with compensation for making funds available to borrowers. These fees help ensure that both parties are incentivized to use the credit facility efficiently, while also compensating the lender for reserving capital.
By understanding commitment fees, businesses can better manage their borrowing costs and financial planning, ensuring that they are prepared for any associated charges when using a line of credit or loan.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.