A revolving credit facility is an established agreement between the borrower and the lender where the line of credit replenishes up to a maximum approved limit. Each time the borrower makes a repayment, its available credit limit increases, and vice versa for drawings. Hence the name, revolving credit facility.
Definition
It is an established credit facility offered by lenders that replenishes up to the maximum credit limit with each repayment. The borrower does not need to apply each time for the credit approval, as long as the credit facility is active.
The borrower does not need to make repayments until utilizing the credit facility. It comes with special features of flexible repayments, renewals, and withdrawal availability at any time.
How a Revolving Credit Facility Works – Approval Criteria
Individual and corporate borrowers both can use the revolving credit facility. The working mechanism and approval criteria remain the same for both types of applicants. It is a popular option used by corporate entities as means of short-term credit facility.
The issuing banks appraise the applicant’s creditworthiness and credit score as with any other loan facility. However, with revolving credit, the banks will emphasize appraising the cash flow of the business. The bank will examine the income statement, balance sheet, and cash flow statement.
For a revolving credit facility, the borrower can increase the approval chances with a steady source of income. More importantly, a steady cash flow will play an important role.
Once approved, the bank will set a maximum upper limit and a time frame for the borrower. The banks usually charge a commitment fee. The approved credit facility is usually a secured form of credit backed by assets owned by the borrower.
A revolving credit facility is issued for the short-term, usually up to one year. The bank may appraise the borrower’s creditworthiness annually to extend the credit facility. However, up to that limit, the borrower can fully utilize the facility as many times as possible. The banks charge variable interest rates on revolving credit facilities. The variable interest rates can fluctuate substantially during the facility time frame.
Types of Revolving Credit Facility
The bank can issue a single revolving credit to an applicant that can further be divided into different uses. The characteristics of a revolving credit facility make all types of utilization similar.
Some common types of revolving credit facilities used by individuals and businesses are:
- Revolving Loan Facility
- Revolving Line of Credit – Home Equity Loans
- Credit Card Facility – Individuals and businesses
- Revolving Letter of Credit facility
- A Personal line of credit
Revolving credits are useful cashflow sources for both individual and business clients. For secured facilities, the bank may approve the credit facility up to 90% of the collateral value. The approval limit may change annually if the borrower’s credit score changes or the bank assesses a decline in the income stream.
The Characteristics of a Revolving Credit Facility
A revolving credit facility differs from the other loans offered by banks. It has its specific uses and its characteristics that distinguish the facility from other loan arrangements.
Here are the key characteristics of the Revolving Credit Facility.
Reusability
It is called a revolving credit facility because the borrower can replenish the funds by depositing cash. The borrower can reuse the facility as many times as possible during the approved time frame. It comes with a cycle of drawing, spending, and repayments as many times as possible.
Moreover, the borrower does not need to make fixed installments. It comes with minimum payable amount that is a fixed percentage of the total utilized credit. The borrowers do not need to repay unless they withdraw.
Maximum Approved Limit
Although the borrower can fully utilize the credit facility many times without approval, it comes with a maximum limit. The bank sets the upper limit by assessing the pledged collateral. The approved limit and other features can change with an annual appraisal by the bank. A high credit score can increase the upper limit, while a degradation in credit score can result in a lower approved limit.
Interest Rate
Revolving credit facilities come with variable interest rates from banks. Importantly, the interest is charged only on the amount withdrawn and not the total credit limit. This comes as the main advantage for the borrowers.
Borrowers can reduce the interest charges by repaying the full outstanding rather than minimum payable amounts. Total interest comes with a fixed interbank interest rate plus the premium charged by the bank. The premium interest charged by the bank depends on the creditworthiness of the borrower.
Commitment Fee and Service Charges
Banks may charge a commitment fee or service charges when approving the credit facility. It is usually a fixed amount.
Bank Covenants
Business borrowers can apply for large revolving credit facilities to support their working capital needs. Banks can improvise covenants to secure the repayments. Apart from the pledged assets, the bank may implement a cash sweep covenant. It forces the borrower to deposit excessive cash to repay the credit utilized. It also keeps the borrower in check for overspending with the approved credit facility.
Example
Companies that forecast fluctuating cashflows can utilize the revolving credit facility. Suppose a company depends on the seasonal hospitality revenue. It can apply for a revolving credit facility of $ 300,000 for its employee payroll expenses. It can estimate the monthly payroll easily while forecasting lower revenue in the off-season. The company withdraws $50,000 monthly and pays interest charges only on that amount. It can reduce the interest by repaying in full, and can reuse the facility as many times as required.
Advantages of Revolving Credit Facility
A revolving credit facility comes with several advantages over other types of loans.
- It comes with a one-time approval, and the borrower can reuse the facility many times. Its flexibility remains the biggest advantage of the revolving credit.
- The borrower pays interest only on the withdrawn amounts.
- The borrower needs to repay only the minimum payable with no fixed installments.
- The borrower can repay in full to reduce the interest costs.
- It is a short-term credit facility with a quick approval procedure.
Disadvantages of Revolving Credit Facility
Along with flexibility and several other benefits, the revolving credit also has its disadvantages.
- It comes with variable interest rates, that can increase significantly during the approved facility.
- The banks consider it an unsecured form of a loan, hence charge higher interest rates.
- The bank may not approve the same credit limit annually every time.
- The bank can include several covenants with the facility such as cash sweep.
- The bank can close or reduce the revolving credit limit with an economic downturn.
Conclusion
A revolving credit facility comes with the flexibility of repayments and reuse. The borrower pays interest only on the utilized amount. The banks charge higher variable interest rates for revolving credits. It offers great flexibility and support for the operating cash flow needs of the businesses.
