What is a Commitment Fee?
The Commitment Fee is a fee charged by lenders to borrowers on the unused portion (i.e. undrawn portion) of a line of credit facility.
- What is a commitment fee?
- Why are commitment fees charged?
- For corporations, what is the standard commitment fee rate?
- How are commitment fees different from interest expense?
Commitment Fee Definition
The commitment letter for a financing arrangement contains a section outlining the specifics regarding the lending terms and conditional provisions.
Furthermore, senior loan agreements with revolving credit facilities (or “revolvers”) are often structured with a commitment fee as part of the lending terms.
Financial institutions, such as corporate banks, charge commitment fees as compensation for keeping the line of credit open and available to be drawn down.
The standard commitment fee typically ranges between a 0.25% to 1.0% annual fee paid to the lender.
Commitment Fee Types
Certain lenders charge a flat fee as a percentage of the total loan amount.
But the far more common type of pricing method is to charge only for the “unused” amount.
Interest is charged on the revolver only on the amount drawn down, per the lending agreement.
Revolver Commitment Fee
The commitment fee is most often associated with a revolver – a line of credit packaged alongside senior loans and meant to be drawn down if the borrower requires immediate short-term liquidity (i.e. “emergency credit card” for companies).
While an insignificant source of returns, commitment fees are still charged by lenders to keep the line of credit available to be drawn upon on an “as-needed” basis.
Commitment Fee Example
For example, let’s say that a bank and a company have agreed on a $100m term loan financing package that comes alongside a revolver with the following:
- Maximum Capacity = $20 million
- Unused Commitment Fee (%) = 0.25%
The $20 million is NOT debt capital that is received immediately, but rather, represents the maximum amount of available capital that can be taken out if the company faces a shortfall in cash.
If we assume the company does not need to draw down from the revolver – i.e. its free cash flows (FCFs) are sufficient to meet all expenses, as well as mandatory repayments – the commitment fee in that particular year is equal to $50,000 (0.25% x $20 million).
Commitment Fee = Unused Revolver Capacity x Commitment Fee %
Commitment Fee vs Interest Expense
Financial models often combine the commitment fee of a revolver into the total interest expense calculation, which is done for simplicity.
Yet, there is one clear distinction between the commitment fee and interest expense.
To reiterate from earlier, the commitment fee is calculated on the remaining amount (i.e. undrawn amount) of the credit facility’s total capacity.
In contrast, interest expense on the revolver is calculated by multiplying the applicable interest rate by the average of the beginning and ending revolver balance for the period.
If a company’s revolver balance increases, the company has drawn down from the credit facility, whereas if the balance decreases, the company has paid down the outstanding balance due.