A revolving loan is a loan that continually renews for a period of time or until the agreement is ended by one party. The debtor is able to withdraw their funds at any time within the agreed amount of time. Similar to a credit card or overdraft account, the debtor can borrow the money, repay the amount and then withdraw again without having to agree to a new loan.
With a standard term loan, once the money is repaid the loan contract is over and the debtor would have to create new loan to borrow more money. The revolving loan allows for this process to be bypassed, by doing so, money and time are saved. Often with term loans there is an origination fee at the beginning of the loan to pay for credit checks and other evaluations with a revolving loan, the fee is only paid once and the institution.
Line of Credit
A firm can establish a line of credit (LoC) with a financial institution whereby the firm can withdraw funds at their will with a certain limit. The LoC can be either committed or uncommitted.
- Committed LoC- There is a legal agreement that requires the financial institution to provide funds to the borrowing firm regardless of their financial situation or credit rating.
- Uncommitted LoC- the agreement is not legally binding and the financial institution can stop the flow of funds if the financial or credit position of the borrowing firm reached an undesirable level. Under this agreement, the firm is under lo obligation to continue lending past a point it deems to be risky.
Because these agreements are usually reviewed on an annual basis they are revolving.
There is a down side to using a revolving loan, there is typically a commitment fee, a fee on the amount of money that is not used up to the limit. For example, assume a firm establishes a committed LoC of $800,000.00,it withdraws $700,000.00 leaving $100,000.00 unused. If the commitment fee is 0.6% then the fee paid would be:
If a nuclear power firm wanted to expand and build new plants it could get a combination of a term loan (from a syndicate) and a revolving loan. Assume the planned expansion costs $5 billion, the firm could get a syndicated term loan for $3 billion and a revolving loan for the additional $2 billion.
For Further Reading
- "A Dictionary of Economics" published Oxford University Press, 2013. Edited by John Black, Nigar Hashimzade, and Gareth Myles Online version accessed [August 17th, 2017].
- Investopedia. "Origination Fee." [Online], Available: http://www.investopedia.com/terms/o/origination-fee.asp [Aug 21, 2016].
- J. Berk et al. Corporate Finance. Toronto: Pearson Canada Inc., 2012, pp. 929.
- J.Black, N. Hashimzade, and G. Myles. (2009) "Revolving Loan." [Online], Available: http://www.oxfordreference.com/view/10.1093/acref/9780199237043.001.0001/acref-9780199237043-e-2710?rskey=a73wa1&result=1, 2009 [Aug 20, 2016]
- R. A. Brealey et al. Fundamentals of Corporate Finance. Toronto: McGraw-Hill Ryerson, 2012, pp. 656.
- R. A. Brealey and S. C. Myers. Principles of Corporate Finance. USA: Irwin McGraw-Hill, 2000, pp.709.