What Is Loan Commitment?

A loan commitment can be referred to as an official agreement between a borrower and the lender. It is a letter in which a commercial bank or any other financial institution promises to lend a specified amount of money to the borrowing party. This is especially beneficial for individuals looking to make a major purchase, such as buying a house.

A loan commitment can be drawn up to address a single lump sum amount if that’s what the borrower requires. You could also treat it like an open-end loan, where the borrower can make repeated withdrawals and repayments simultaneously until they have drawn up to the predetermined limit.

To learn about loan commitment in greater detail, you can give this article a read to get yourself adequately informed!

Types of loan commitment

Simply put, there can be two types of loan commitment: a secured loan commitment and an unsecured loan commitment.

Let’s see how they prominently differ from each other:

1 – Secured loan commitment

A secured loan commitment is partially dependent upon the borrower’s creditworthiness. To the evaluation of an adequate credit report, a big part of securing this loan is based on the collateral.

The loan is backed up by collateral that’s at least worth the exact value of money borrowed from the lender. Therefore, the interest rate on this debt is also significantly lower. For example, you can offer your home as collateral to secure the loan.

2 – Unsecured loan commitment

On the other hand, an unsecured loan commitment solely depends on a borrower’s creditworthiness since the debt is not backed up on any collateral. It should be noted that an unsecured loan commitment is usually never offered unless the borrower has an exceptional credit score, and they also agree upon accepting a comparatively higher interest rate on their loan repayment.

Generally, the higher an individual’s credit score, the more chances to secure a higher credit limit.

A brief overview of loan commitment process

black calculator beside black pen on white printer paper

In simple terms, a loan commitment can be considered as a promising letter from the lender’s side, which could be a mortgage bank, commercial bank, or credit union. This letter states that the lending party has agreed to loan a specific amount of money to the borrower under certain terms and conditions. The loan is not issued when the contract is drawn, but the commitment letter is proof that the debt is approved.

This is where things might get blurry for some people who confuse loan commitment with pre-qualification or pre-approval. If it’s the same with you, you can refer to the following section to understand precisely what loan commitment is and how it differs from the two mentioned terms!

The primary distinctions between pre-qualification, pre-approval, and loan commitment

Since loan commitment is mostly a part of the home mortgage financing process, let’s understand the stated terminologies from that reference to keep things simple.

Since the terms “pre-qualification,” “pre-approval,” and “loan commitment” all sound like they might mean the same thing, this creates confusion for the home buyers from the very beginning. However, in reality, these words don’t just hold different meanings but are also completely distinct stages of the mortgage financing approval process.

Here’s a step-by-step explanation of what these terms infer:

Step 1 – pre-qualification

Pre-qualification is a simple process that provides a basic guideline regarding how much money the borrower can afford to spend on their new home, depending upon their current financial situation. This step can be performed online, and it only takes a few minutes to determine the calculated amount.

Since the pre-qualification helps you estimate your housing budget, borrowers should get it done before they even start looking for their home. That’s because once they have an idea about how much they can afford, they can shortlist the property choices while remaining under the correct price range.

Step 2 – pre-approval

After getting pre-qualified, you can further increase your chances of securing a home by getting pre-approved from a lender as they evaluate your creditworthiness based on different criteria. By creditworthiness, we mean the likelihood of you paying back the loan on time.

Since pre-approval builds a stronger foundation for one’s credibility, homeowners always prefer that when selling their house to the buying party. It gives them the peace of mind that the borrower has a solid plan of action, and therefore, it’s likely that all transactions will be made in time.

In short, sellers never want to put their property off the market until they’re sure the transactions will be completed. Hence, pre-approval acts as the buyer’s credibility report.

Step 3 – loan commitment

Once the seller has accepted your offer, this is where the buyer requests loan estimates from multiple lenders. The lender is selected within three days afterward, based on which lending party is willing to offer the best terms and conditions to the borrower.

After the lender has been chosen, this is where we enter the loan commitment stage. This can be referred to as the beginning of the final stage in a mortgage financing approval process. The lender evaluates the buyer’s files on a couple of conditions, and once they’re satisfied, a loan commitment letter is drawn to confirm they’re willing to fund the purchase.

It should be noticed that, unlike the pre-qualification and pre-approval stages where only the buyer’s worth was evaluated, this step assesses both the buyer and the collateral’s value, which is mostly the house itself.

Conditions for loan commitment

There are two conditions for loan commitment that need to be met before the proceeding of full approval from the lender’s side. These include:

Condition #1 – evaluation of property

The property should meet the lender’s standard in terms of physical condition and monetary value. Since the lender funds the property, they must ensure it is a reasonable sound investment for them, should the borrower default on the loan and they acquire it.

This process includes an official inspection of the house carried out by professionals to evaluate the property’s physical condition, structural concerns, and net worth.

Condition #2 – evaluation of borrower’s financial status

The buyer’s financial standing must also meet the lender’s standard. Simply put, the lender has the right to evaluate whether the buyer can repay the loan on time. This is typically concluded by assessing the borrowing party’s financial situation, credit score, state of employment, and prior debts (if any).

The final verdict

Loan commitments are flexible and can be quite helpful when an individual is looking to pay for unexpected short obligations or planned long-term obligations. Plus, since secured loan commitment has a lower interest rate, the repayment process is much more affordable for that as well.

However, it should be taken into account that borrowing too much money can also put you in a tricky spot, even when you are careful. Case in point, you might end up forfeiting your collateral when the interest charges pile up unexpectedly. Ultimately, it’s best to choose this option only if you’re sure you can repay the amount of money borrowed along with the interest charges.