A prearranged credit agreement is a lending arrangement between a borrower and a lender that outlines the terms of a future credit extension. This type of agreement is commonly used in business financing and can be an effective way for borrowers to secure financing in advance of its needed use. Here’s what you need to know about prearranged credit agreements.
How does a prearranged credit agreement work?
A prearranged credit agreement is essentially a promise by a lender to lend money to the borrower at a future date. The lender will typically evaluate the borrower’s creditworthiness and determine the maximum amount that can be borrowed under the agreement. Once the borrower needs the funds, they can draw on the credit line and use it for their business needs.
Unlike traditional loans, prearranged credit agreements have a set end date and a limit on the amount that can be borrowed. The borrower typically pays interest only on the amount drawn, not the entire credit limit. This can be a cost-effective way to finance business expenses because interest is only paid on the amount borrowed.
Why use a prearranged credit agreement?
There are several benefits to using a prearranged credit agreement:
1. Flexibility – A prearranged credit agreement provides businesses with flexibility in their financing needs. It allows them to access credit when they need it without having to apply for a loan each time.
2. Lower interest rates – Since the lender has already agreed to lend money to the borrower, the interest rate on a prearranged credit agreement is typically lower than that of a traditional loan.
3. Improves cash flow – A prearranged credit agreement allows businesses to manage their cash flow better, especially during times of uncertainty.
4. Builds a relationship with lenders – Establishing a prearranged credit agreement builds a relationship between the borrower and the lender. It shows good faith and trust in the borrower and can lead to additional future financing opportunities.
What are the risks of using a prearranged credit agreement?
There are some risks associated with prearranged credit agreements that businesses should be aware of:
1. Draw fees – Lenders may charge fees each time the borrower draws on their credit line.
2. Loan commitments – Some lenders require businesses to commit to a minimum amount of borrowing, which can be a disadvantage if the business doesn’t need to borrow that much.
3. Creditworthiness – Businesses should ensure they have good creditworthiness before seeking a prearranged credit agreement. Lenders will typically evaluate the business`s credit history before approving the agreement.
Prearranged credit agreements can be an effective financing structure for businesses that need flexibility in their financing needs. They provide businesses with access to credit when they need it and allow them to manage their cash flow more effectively. However, businesses should be aware of the risks associated with prearranged credit agreements and ensure they have good creditworthiness before seeking a lending arrangement.