What is a Commitment Fee?
A commitment fee is a fee that is charged by a lender to a borrower to compensate the lender for keeping a credit line open. The fee also secures a lender’s promise to provide the credit line on the agreed terms at specific dates, regardless of the conditions of the financial markets. The fee compensates the lender for the risks associated with an open credit line despite uncertain future market conditions and the lender’s current inability to charge interest on the principal.
Lenders send borrowers commitment letters stating the commitment fee and explaining how the fee was determined. Typically, a lender charges a flat fee or a percentage of the undisbursed or future loan amount. The percentage fee generally varies between 0.25% and 1%. The fee is usually paid after the credit agreement’s been finalized. However, the amount can be charged periodically if it is charged on the undistributed loan. In such cases, the fee is based on the average balance of the undisbursed loan amount.
Commitment Fee vs. Interest
Frequently, commitment fee and interest are often confused with another. Although there are similarities between the two, there is a significant difference between them. A commitment fee is charged on the undistributed or future loan, while interest is calculated on the amount that has already been distributed.
Company ABC obtained a $40 million credit line from Bank X at a 3% interest rate and with a 0.75% commitment fee to keep a credit line open. The fee is charged yearly on the unused portion of the credit line. ABC Corp. used $25 million in the first year. Thus, the fee paid to Bank X in the second year will be calculated in the following way:
Commitment Fee = Unused Amount of Credit Line × Commitment Rate
= ($40m – $25m) x 0.75% = $112,500
The situation above is an oversimplified example of commitment fee calculation. Generally, the fee is calculated periodically based on the average unused credit line balance, multiplied by the fee rate and by the number of days in the period.
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