What is a Letter of Commitment?
A letter of commitment is a formal binding agreement between a lender and a borrower. It outlines the terms and conditions of the loan and the nature of the prospective loan. It serves as the agreement that initiates an official loan borrowing process. A commitment letter contains information about any costs arising from due diligence and administrative procedures before the loan gets to the approval stage.
The letter of commitment outlines the amount of attorney fees, any fees incurred in preparing the loan documents, amount of the loan, interest rate, repayment terms and period, collateral, and closing conditions.
Objectives of a Letter of Commitment
The primary objective of a commitment letter is to brief the borrower that the loan application has been processed and cash is available to the applicant. However, for the borrower to access the funds, he/she must meet the specific terms and conditions set by the lending institution. If the borrower accepts the terms and conditions of the loan, they need to sign the agreement. If the borrower fails to agree to the terms, the loan application will be denied or revoked.
The letter of commitment specifies the amount of a loan that the bank is willing to offer the borrower. The amount may be below or above what the borrower requested. The loan commitment serves as a formal record of the loan processing but is not the loan contract. After accepting the terms of the loan, the borrower and lender sign the actual loan agreement to dispense the funds.
A borrower may use the letter of commitment as proof to interested parties that they have a line of credit available to acquire an asset. It gives the interested parties confidence that the borrower will honor the promise and purchase the asset before the expiry of a specified duration. For example, when a person is applying for mortgage financing from a bank, he/she may present the letter of commitment to the owner as proof that they have sufficient funds available to close the purchase. This gives the property owner confidence that the borrower can close the transaction within the agreed time period. The letter of commitment serves as an assurance that a transaction can be financed up to a certain limit indicated by the bank.
Contents of Commitment Letter
The basic contents of a letter of commitment include the following details:
- Names and addresses of the borrower and lender
- The type of loan applied for
- The loan amount
- The agreed upon loan repayment period
- The interest rate for the loan
- Date of lock expiration (if the loan is locked in) for the interest rate
- Estimated monthly repayments of the loan (broken down into the principal amount, interest, taxes, and insurance applicable)
- Type of contracted property and address
- Terms and conditions of the loan
- Effective date and commitment fees
- Evidence of title of property and information that there are no liens or adverse covenants to the title
- Cancellation policy
Obtaining a Letter of Commitment
Borrowers must go through several steps before getting the commitment letter. The first step is to approach several lenders and talk to them about a loan application. Here, lenders use the numbers provided to them to come up with an estimate of how much the borrower can afford to borrow. The borrower also discusses their income, assets, and previous credit history with the lender to determine their ability to repay the loan.
If the lender is satisfied with the borrower’s financial situation, then the borrower commences the loan application process. The following are the initial steps that the borrower will take:
1. Fill out the loan application
This is the first step in the loan process. The borrower provides their personal information, such as address, current assets and debts, current income, loan amount requested, and social security number.
2. Give access to the credit report
The borrower then allows the lender to access their credit report. The lender requires the credit report to review the borrower’s credit payment history and their current credit level to determine whether to advance credit or not. Some loans require borrowers to achieve a particular minimum credit score for the loan to be approved.
3. Submit financial documents
The lender will also require the borrower to submit financial documents such as pay stubs, tax returns, and proof of asset ownership. Depending on the lender and amount of loan requested, the lender may require financial records for a specific duration of time. The lender reviews these documents to determine the borrower’s eligibility for the loan.
Where the loan is to be used as a mortgage to purchase a home, the lender will provide a pre-approval letter pending the letter of commitment. The lender will then send the borrower’s file to the underwriter for review, while the borrower shops for a home using the pre-approval letter. The borrower can bid and sign sales contracts with realtors.
For the lender to provide the letter of commitment, the borrower must provide all verification documents requested, an appraisal of the property that the borrower wants to buy, and a sales contract signed by all parties in the transaction. The letter of commitment states the approved loan amount, as well as the terms and conditions that the borrower must meet before signing the final loan agreement.
Expiration of a Letter of Commitment
A letter of commitment comes with an expiration date, which is usually disclosed in the document. Therefore, if the loan fails to fund before the stated expiration date, the lender is not obligated to lend the money under the initial terms of the loan. Once the closing period ends, the borrower will need to renegotiate the terms of the loan afresh with the lender and obtain a new commitment letter.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following CFI resources will be helpful: