Backup Line

finance a la shmoop what is a line of credit? oh I'll definitely pay it back. [ man talks to camera]

yeah, that's a line of credit, but it's just a line like can I buy you a drink

or do you come here often or I bet my mother would love you, in financial real

life a line of credit or LOC if you just like using acronyms to make yourself

seem are keenly smart, is deb,t or rather an LOC is an option to take on debt. why [man in front of power point]

would somebody want an option to take on debt? well here's why.

yep companies can't ordain their futures. they don't know what's coming .but paying

a few bucks today for financial life insurance tomorrow is usually a really

good idea because the skies are not always sunny all day. so a company that [robot assembly line]

makes shoelace tying robots might be doing great today but there's a big fat

product release coming and they have no idea if it'll do well right away or take

three years to catch on. or you know rip people's feet off well who knows, maybe

people will actually be able to tie their own shoelaces by then. what do you

think America? how are we doing but yeah it's unpredictable this sort of thing [man sits on a couch]

happens to tech companies all the time. so while the company doesn't need cash

today they may need it in the future .so they pay a bank or lender a small token

amount in return for that lender guaranteeing that the money will be

there at a set price in rent and set terms at some point in a defined future.

ie the next three years or something like that. that is, you know prevailing

rates or five percent they might pay half a percent to guarantee they can

borrow it 10 million dollars at 5% but, we'll get into. that all right if a [smiling man on the phone]

company does in fact decide to exercise its option to draw down cash from its

line of credit or rather to get the bank to wire the cash they have reserved into

the company's own bank account then usually it just starts paying interest

or rent on the money the day it's borrowed, just like it would have if it

borrowed money at the outset. well why wouldn't a company just borrow money

today and have it stuffed under its mattresses? [woman holds a stash of cash]

well because almost always the option to draw down money costs a fraction of the

interest it would cost to actually borrow the money itself. so we have a

company who wants the right to borrow ten million bucks and

they're willing to pay half a percent per year for a guarantee to be able to

borrow that money I'd say five percent per year when or if they borrow it. if

they never borrow it that half a percentage is wasted. [definitions on the screen]

well the half a percent line of credit option fee is 50 grand a year and let's

say two years go by in the company doesn't need the money.

they've just wasted that fifty grand a year each year. but then they borrow all

of it in year three and guess what in those three years interest rates went up

two percent 3 percent four percent something like. that yeah it could happen.

so the company paid 100 grand for the option to borrow the money at five [equations ]

percent interest, and yes that hundred grand is a lot of dough ,but compare it

with the cost of borrowing had the company borrowed all ten million right

away. well had they done that they would have paid five percent per year in

interest on that ten million bucks or five hundred grand a year and that's

times two years .so it would have cost them a million dollars in interest had

they borrowed all the money right away. instead miserly wiserly, they only [man scribbles with a pen]

paid a hundred grand for the option for two years because they didn't need the

money right away and that line of credit structure saved them nine hundred

thousand dollars in borrowing costs. a nice job mr. CFO. so why isn't it free to [thumbs up]

just reserve a line of credit with a bank? like why do they charge anything

when they're not actually loaning out money today? well the bank has to

allocate gets finite resources to accommodate that line of credit drawdown.

sure enough Murphy's Law happens at work and the company will want to exercise

the LOC and draw down the money from the bank at just the worst time in history [woman frowns in front of a bank vault]

like say in the middle of 2008 or 9, when nobody had anything right. okay.

well banks have tightly regulated laws or covenants around which they can

borrow money from the Fed or the government at say 2%, then mark it up to

4% and lend it out. and they make money on that spread right? so if the bank had

tons of LOCs out there it could be bad news if they weren't charging a little [hands reach for cash]

something for them. and no a credit card essentially is a line of credit you fill

out a bunch of forms swear and then pinkie swear to pay back the money .if a

month goes by and you don't pay back the money you owe well then you

get charged enormous rates for borrowing. it but if you do pay it back, the rates

are really low maybe you have a small annual fee although most credit cards,

they don't even have those anymore. but more directly, the fee is paid by the merchant

ie the earring store that sold you the seven belly button rings for forty bucks. [ pierced and tattooed woman holds document]

each in the form of a transaction fee that is, the $280 you would have spent on

a constellation for your stomach, the merchant paid the credit card company

about 1% or 280 for managing the bank in that transaction. what about as much as

you're gonna be spending on cotton swabs and antibacterial soa.p I hope you

weren't planning on wearing a tube top anytime soon. anyway that's a line of

credit .use it wisely. it can bite you [woman with red stomach grimaces]