Line of Credit Modification

A line of credit is typically a one-year interest-only loan in which a bank or other lender approves funds for a borrower's use. The borrower can use these funds as necessary and, upon repayment, the credit line is replenished. A line of credit can theoretically be renewed for years at a time. During the life of the loan, circumstances of the borrower, the lender, or both may necessitate a modification. There are several aspects of a line of credit that can be modified.

Credit Limit

The most common type of modification is an increase or a decrease to the credit limit. Typically, an increase is voluntary, while a decrease is mandated based on financial capability. To be approved for an increase, you must exhibit the capacity to pay the line even if it is fully extended. You must also have sufficient collateral coverage based on the bank's advance rate. For example, a bank may advance 80 percent of the value of an owner-occupied property, but only 70 percent on an investment property. Banks typically review lines of credit on an annual basis. If they discover that a borrower is lacking in capacity or collateral, they may reduce the line to fall within policy guidelines.

Rate

Lines of credit are most often based on a variable rate. The most common rate index is the prime rate as published in the Wall Street Journal (WSJ). The rate will float on a daily basis. This means that the rate will change when a new prime rate is published in the WSJ. So if prime is 3.25 percent on Jan. 1 and 3.5 percent on Jan. 2, the rate will change accordingly. Most rates also carry a spread. For example, if the rate is prime plus 1 percent, the 1 percent is the spread. Common rate modifications are increasing or decreasing the spread or adding a floor. A floor is the lowest rate a line of credit can carry. For example, if your rate is prime plus 1 percent with a floor of 5 percent and prime is 3.25 percent, your rate will not go below 5 percent, even though prime plus 1 percent equals 4.25 percent. Banks typically modify lines to add floors in declining rate environments.

Extension/Renewal

A line of credit is usually a one-year loan with an annual review. At closing, the borrower will sign a loan agreement in which she agrees to provide updated financial information each year. Upon receipt of this information, the bank will review the line and modify the maturity date accordingly. Typically, it will extend the loan for an additional year. If financial information is not available at maturity, the bank may approve a temporary extension of anywhere from 30 to 120 days to give the borrower time to compile the necessary documentation. A borrower in good standing will typically go through this modification process each year.

Term Out

A term out is usually imposed by the bank rather than the borrower. When a borrower has a line of credit that is fully extended without principal reduction, it is considered "evergreen." When a line reaches evergreen status, the bank will modify the loan from an interest-only one-year loan to an amortizing multi-year loan. The rate, term and other conditions will vary based on the borrower's situation. Alternatively, a borrower may no longer find the line of credit necessary and request the modification to a term loan to avoid paying the entire principal balance at once.