ShmoopTube

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

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

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

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

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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]

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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company who wants the right to borrow ten million bucks and

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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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]

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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