Financing processes include many components, such as agreement letters, rates, terms, notes, and more. A loan commitment is a letter produced at the beginning of a loan or mortgage. It is also called a marketing loan commitment as it is provided by the lender and states its plans to approve the loan. When a buyer receives a loan commitment letter, the lender has reviewed the loan application and wants to move forward with the remaining process to offer you a loan. However, the applicant must comply with what was submitted in the application. In this post, you’ll learn about loan commitment with the help of detailed examples.
What Is a Loan Commitment?
A loan commitment is an agreement letter issued by a bank, credit union, or any financial institution to offer a loan to a borrower. It is a promising letter that states that the lender will offer a loan or credit soon, according to the rates and terms of the loan agreement. The letter also indicates that you’re eligible for a loan, and the lender promises to provide the loan amount according to its terms.
When a borrower applies for a loan, the lender reviews the application, which includes evaluating creditworthiness and financial stability. Once the application has been reviewed and the loan underwriting process is complete, the borrower receives the loan commitment letter. Loan commitments suit borrowers who want to make major purchases or buy homes. The loan can be in any form, including revolving credit or a single lump sum. Revolving credit or line of credit allows the borrower to draw cash as needed but up to a limit.
Loan commitments can be secured or unsecured depending on the type of loan. A secured commitment is a loan that is backed by collateral. On the other hand, an unsecured commitment has no security or collateral; it is based on the borrower’s credit history and financial stability.
Loan Commitment Vs. Pre-Qualification Vs. Pre-Approval
To obtain a loan from the lender, the borrower can get three letters: loan commitment, pre-qualification, and pre-approval letters. Of these three options, pre-qualification is the least valuable. It is a letter that indicates that the borrower wants to check their eligibility for a loan. It is an informal process and can be done verbally or in written form. Pre-qualification doesn’t require formal documentation; thus, the information provided by the borrower isn’t assessed properly. It is only helpful for the borrower to check if he is eligible for a loan.
On the other hand, a pre-approval is more valuable than a pre-qualification letter. To provide pre-approval, the lender reviews the details the borrower provided, including financial documents. The lender will usually assess the credit report, bank statements, tax returns, pay stubs, and proof of income. A pre-approval letter shows that the borrower is legally qualified to obtain a loan. The letter also includes the maximum amount a buyer can obtain as a loan from the lender. However, a pre-approval letter still doesn’t guarantee that the borrower will get a loan. It just gives more value to the borrower in the eyes of the lender and shows that the borrower is qualified to obtain a loan.
Lastly, a loan commitment letter has the most value regarding loan agreements. This letter is issued by a mortgage lender or a bank after the borrower has gone through a strict underwriting process. An underwriter prepares the letter after going through the pre-approval letter. A loan commitment is proof that the borrower will get the loan. This letter also states the type of loan you’ll get, for example, conventional, USDA, etc. Of all these three letters, a loan commitment letter is the most beneficial for the borrower, especially if the purpose is home buying.
How Does Loan Commitment Work?
To get a loan commitment letter, the borrower must review his credit history and remove any errors. Copies of credit reports are available from all three major credit bureaus. The borrower must have a good FICO score to get the best rates and terms. The borrower can then apply for a loan; below, I’m explaining the steps that a home buyer may need to get a loan:
- Obtain pre-qualification to check their eligibility for a particular loan. This letter also helps the borrower know about which loan rates to consider.
- After checking their eligibility for a loan, the buyer can obtain a pre-approval letter from the lender.
Types of Loan Commitments
As mentioned earlier, loan commitments vary according to the types of loans. While secured and unsecured commitments are the broad categories, the commitments are further divided into subcategories. The following are the different types of loan commitments:
Revolving Secured Loan
A revolving loan commitment, also known as an ‘open-ended loan commitment,’ is a letter that allows the borrower to use the loan in intermittent payments during the loan term. However, the borrower must make timely payments to keep using the funds. As the borrower continues to pay the principal, the loan balance reduces, and the borrower can use the proceeds. Revolving a secured loan gives flexibility to the user to access funds as needed. The loan is also guaranteed by collateral which may be an asset or cash.
Non-Revolving Secured Loan
Non-revolving secured loan commitment is for a closed-ended loan commitment. This commitment letter says that the borrower can obtain a lump sum and the account is closed when the loan is repaid. Since this is a secured loan, the loan is backed by collateral. For instance, if a person buys a home through a non-revolving secured loan, he gets payments as a lump sum, and when he repays the whole amount, the account is closed. A commitment letter for this type of loan is a non-revolving secured loan.
Revolving Unsecured Loan
Revolving unsecured loan commitment isn’t backed by collateral and is based on the borrower’s creditworthiness. This is also an open-ended loan commitment, but the difference is that there is no security in the form of cash or assets. The higher the borrower’s credit score, the higher the credit limit. Since it is an unsecured loan, the interest rate is higher than the revolving secured loan. A revolving unsecured loan commitment states that the borrower can withdraw cash as needed during a predetermined term.
Non-Revolving Unsecured Loan
A non-revolving unsecured loan commitment is a closed-ended loan commitment that is not backed by any collateral. The commitment for this type of letter indicates that the borrower can obtain a lump sum according to his credit history. The better the credit score, the higher the credit limit. Once the borrower receives the payment, he will have to pay the loan in regular monthly payments. The account closes when the loan matures.
Advantages and Disadvantages of Loan Commitments
Loan commitments help pay unexpected financial obligations. The open-ended loan commitments are quite flexible in such cases. Borrowers might consider getting a HELOC which offers low-interest rates for a more affordable solution. Loan commitment for such loans can make it easier to pay off long-term debts. Besides that, secured credit cards allow borrowers to rebuild their credit.
There are a few downsides to loan commitments too. For instance, a secured loan commitment allows borrowers to obtain large amounts of loans, but they’ll have to lose the collateral if they cannot repay the loan. So, if a borrower has obtained a loan commitment and puts his home as collateral, he will lose his home if he defaults on the loan. Besides that, unsecured loan commitments involve higher interest rates which means that loans will be costly.
Mortgage commitment letters are similar to loan commitments, specifically for buying homes. A lender will approve the loan if the borrower continues to comply with the conditions on the mortgage commitment. The following are the two main types of mortgages:
Firm Mortgage Commitment
A firm mortgage commitment states that the mortgage lender will offer the money the borrower needs to buy a property. It is proof that the lender has assessed the documents and that the borrower has provided all the answers required during the mortgage process. Firm mortgage commitment also needs an additional fee to come into effect.
Conditional Mortgage Commitment
Conditional mortgage commitment doesn’t directly state that the lender has approved the loan for the borrower. This commitment letter states that the lender will only provide a loan to the borrower if certain conditions are met. For instance, the conditions may include a home inspector inspecting and analyzing the property, and an appraiser will verify that the home is worth the price.
Loan Commitment Example
Example 1: Suppose person-A wants to get a loan to purchase a home worth $250,000. After pre-qualifying for the mortgage, person-A receives pre-approval. He then uses this pre-approval letter to buy a home, as the letter states that the buyer is qualified to get a loan. The pre-approval letter made person-A an attractive buyer in the eyes of the lenders. However, a lender demands a loan commitment letter to offer the mortgage. Person-A obtains a loan commitment which has the following details:
- Borrower’s income, asset documentation, and credit details
- Loan amount: $250,000
- Interest rate: 3.75%
- Loan type: Conventional mortgage
Besides that, the loan commitment also lists the conditions and states that the borrower has been approved for a loan. This commitment letter proves that the buyer’s lender has approved the loan for buying that home.
Example 2: Sarah and John want to buy the same property through a mortgage. Now it’s up to the seller to sell the home to any one of the buyers. The seller requests a few documents to assess the buyers’ financial standing. After evaluating the documents, the seller decides to sell the property to Sarah. Upon inquiring about his rejection of buying the property, John learned that the seller preferred Sarah because she has a loan commitment, and John could only provide a loan pre-approval letter.
Frequently Asked Questions
Does a Loan Commitment Letter Mean that the Borrower is Approved?
A loan commitment letter doesn’t mean you are approved for a loan. However, a loan commitment letter is a positive thing for the borrower. To approve a loan, the lender will provide the final agreement letter stating the loan terms, rates, and everything related to the loan. The lender will approve the loan after reviewing more documents.
Can a Loan Be Rejected After a Loan Commitment?
Loan commitments are of two types: a final commitment letter and a conditional commitment letter. If it’s a conditional commitment letter and the borrower doesn’t meet the conditions, the lender can deny the loan. A final commitment letter states that the borrower will get a loan; in this case, the lender cannot deny the loan.
How Long Does it Take to Get a Loan Commitment?
Getting a loan commitment mostly takes around three to six weeks. The loan application will be processed when the borrower submits a loan application for approval with all the documents. The lender will review all the documents, and an underwriter will appraise the documents and other information provided by the borrower. Once the underwriter evaluates the documents and approves the commitment, the lender issues a loan commitment letter to the borrower.
What to Know for the Real Estate Exam
Loan commitments are valuable financial tools that help borrowers obtain loans. It is an important document that proves that the borrower is qualified to buy a home or get a loan. A borrower can show the loan commitment letter to a real estate agent so that he can help with the search for a prospective home seller. If it’s a mortgage commitment, the borrower needs to pay special attention to whether it’s a conditional or firm mortgage commitment. I hope that you’ve understood how loan commitments work. Learn more about other real estate definitions to ace the real estate exam.