An unfunded line of credit is one that a bank issues to a borrower, but is not borrowed upon at the moment it is issued. The bank or lending institution will honor any future draws upon the unfunded line of credit, but does not need to make any money available until the moment the customer requests it.
How is an unfunded line of credit different than a traditional loan?
If you take out a mortgage, the lender must immediately make the amount of the mortgage available so you can buy that dream house. This is considered a traditional loan transaction. Other traditional loan transactions include automobile loans, student loans and other consumer loans. An unfunded line of credit is a line of credit which is reserved for future use and is not fully funded upon issue.
Borrowers of Unfunded Lines of Credit
Borrowers of unfunded lines of credit can be either individual retail customers or businesses. Businesses such as hedge funds and insurance companies are customers of unfunded lines of credit, and they most commonly use them as an emergency fund. Retail customers can also acquire unfunded lines of credit in the form of home equity lines. Unfunded loan commitments, whether to retail or corporate clients, represent liabilities to both borrowers and banks.
Risk of Borrower Default
A borrower can default after drawing upon the line of credit, causing a major problem for the bank which acted as a lender. For example, if a major catastrophe happens which requires an insurance company to pay out claims for which it does not have sufficient cash reserves, that insurance company may draw upon its unfunded line of credit. If the insurance company is unable to pay back what it borrowed from the bank and files for bankruptcy, the bank must count the unrecovered money as a loss.
Risk of Bank Default
Unfunded lines of credit pose major risks for banks. Because the bank must honor the line of credit at any given point in the future, it must have enough cash to do so. If a bank issues too many unfunded loan commitments, and a high number of them are unexpectedly drawn upon, the bank will be unable to honor the loan commitment. Banks are required to report unfunded lines of credit quarterly to the United States government's Federal Deposit Insurance Corporation. Every bank limits the number of unfunded credit lines it will issue to mitigate liability.
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