For some loans, especially personal loans, the full amount of the loan is dispersed all at once to the borrower. Certain other loans, most commonly credit card loans, are revolving loans which can theoretically be used forever and never be completely paid off so long as minimum payments are made. Another type of loan, most common in business, involves a maximum loan amount which can be accessed as needed, but only for a certain period of time. This period is known as the draw period.
The draw period provides the borrower with the flexibility to access additional funds as needed without the extra expense of taking all the funds at once, and thus paying interest on an amount that is more than actually needed.
The draw period of a loan is usually determined up front and explicitly defined in the contract terms of the loan. The draw period consists of a time frame during which the credit facility may be accessed, and may include an increasing maximum as the loan gets older.
The draw period allows for a lending institution to provide a loan to the borrower with flexible terms and conditions, but without indefinite exposure. For example, a bank may provide a loan to a businesses that currently looks healthy with a 5-year draw period. The idea is that the bank can be reasonably sure that the finances of the business will not deteriorate over those 5 years to an unacceptable level, and after that, any subsequent loan would have to be re-approved. Similarly, a home equity line of credit may be extended with a 3-year draw period so that the lender is not exposed if market conditions or the borrower's finances worsen.
Shorter draw periods often come with lower interest rates. The shorter the term, the lower the risk that a company's finances will become unstable during the draw period, and thus the risk is lower for the lender. For the borrower, a longer draw period provides greater flexibility to have access to capital when the need arises.
Companies and individuals with an expiring draw period will often make the mistake of taking out the remaining loan principal, "just in case." While they may have qualified for a different loan prior to such action, they may now be seen as a risk for having too much debt to qualify. This leaves the borrowers unable to refinance the loan and at the same time responsible for additional interest payments.