Leveraged loan: how it works, pros and cons
  • August 31, 2021
  • admin

In terms of risk associated, different types of loans have come into the scenario. Unlike a personal loan, mortgage loan, car loan, house loan, this leveraged loan also offer instant liquidity to borrowers. But here, the risk factor is really high for lenders.

Generally, lenders used to avoid those borrowers who do not have good repayment history and suitable credit score. Besides, some money lenders also ask for LVR (Loan to Value Ratio), for which a borrower needs to prove his ability of repayment by paying 20% of the loan instantly. However, here we will talk about such type of loan, which does not require a good credit score.

What is Leveraged loan?

It is a type of borrowing where lenders provide loans to borrowers even after having pending debts and a low CIBIL score. Generally, financial intermediaries like banks and NBFCs offer such loans to borrowers. But here, the borrower is not an individual. Instead, the borrower is a large organisation that merges finance or even new talent acquisition and promotes products.

There is no doubt that such loans play a primary role in the upliftment of society. The money is lent to those borrowers who generally want to do something big to fulfil the requirement of the business. Meanwhile, there is an exact definition of when and how corporate borrowing has become leveraged loan because different money lending bodies have evolved their own criteria.

For instance, when a financial intermediary lends money to a corporate body that does not possess a good credit score and whose income is five times less than the outstanding owing amount. In this case, the only purpose of applying for a leveraged loan is to withstand loss and invest money in the business to make a profit.

How does Levered loan work?

While lending money generally, a money lender used to declare several terms and conditions that a borrower must adhere to. So, if you thought that money lenders would completely overlook the outstanding debt amount, then you are wrong. Basically, the lender never forgets to analyse the risk factor of a borrower.

The only way to use that increasing risk factor is by imposing a high-interest rate. As a result, the lower credit score will ultimately heighten the rate of interest. Only because of taking the high rate of interest the moneylender is imposing such high rates.

Apart from fixed interest rate sometimes this type of loan also offer a flexible rate of interest. This clearly hints that the interest rate may be higher or lower depending upon the market condition. As a result, the repayment amount and outstanding amount may also change with time.

LIBOR (London Interbank Offered Rate) operates the interest rate of leveraged loans on behalf of the lenders. Generally, lenders would like to sign a treaty between them to maintain all the terms and conditions. Usually, this treaty is for both participants (borrowers and lenders), and they both need to adhere to all those conditions.

Sometimes, lenders used to involve investors within leveraged loans. Generally, the financial intermediaries who offer this leveraged loan operate as per the ‘originate-to-distribute model’. This model indicates the involvement of funds from share market investors.

Pros and cons of Leveraged loan

  1. Such private loans in the UK solve the problem of the financial crisis. As there is no hindrance to get funds so, one may borrow them without any worry. A financial intermediary quickly approves the fund without analysing the ability.
  2. It helps corporate bodies to invest money in promotional activities and even in the new acquisition. So, indirectly, the lenders of leveraged loans fulfil the necessity of the business industry, contributing to a great extent. On the other hand, the economic growth of the country also gets a good rise.
  3. A business organisation can easily borrow money only through the leveraged loan even after a low credit score. The borrower does not have to take the risk as the lender is taking the risk here. Therefore, a borrower needs not worry about a good credit score.
  4. Even after having lots of outstanding dues from other lenders, money lenders would like to lend leveraged loans. It saves a borrower from repaying other debts and utilising that fund for expanding the business.
  • Cons: 
  1. A high rate of interest is the central issue of the leveraged loan. Although a corporate body can quickly get immediate fund assistance, it comes in exchange for a high-interest rate. In most cases, it has been observed that organisations that borrow such loans fell into more debt. As a result, it becomes difficult for that company to carry on another debt despite having so many others.
  2. Lenders are the high risk-takers. To offer leveraged loan service, a financial intermediary needs to take over a huge amount of risk. The only reason is, borrowers, do not have any good credit history.

In most cases, defaulters and low credit rate bearers apply for such loans.

So, it is undeniable that leveraged loan ultimately serves a good many benefits. But it has some cons too. However, it is up to you whether you want to borrow leveraged loan or not.

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