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- Loan Covenant - Defintion, Types, Why They're Used
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A loan covenant is a condition in a commercial loan or bond issue that requires the borrower to fulfill certain conditions or which forbids the borrower from undertaking certain actions, or which possibly restricts certain activities to circumstances when other conditions are met.
Typically, violation of a covenant may result in a default on the loan being declared, penalties being applied, or the loan being called. The legal provision in the loan agreement providing for the loan to be "called" is the "acceleration clause": once the buyer defaults, all future payments due under the loan are "accelerated" and deemed to be due and payable immediately.
Covenants may also be waived, either temporarily or permanently, usually at the sole discretion of the lender.
Function
Covenants are undertakings given by a borrower as part of a term loan agreement. Their purpose is to help the lender ensure that the risk attached to the loan does not unexpectedly deteriorate prior to maturity. From the borrower's point of view covenants often appear to be an obstacle at the time of negotiating a loan and burdensome restriction during its term.
Proponents of the use of covenants, emphasizing the early warning function of covenants, take the case further by arguing that well-designed covenants provide not only timely performance indicators but also open up lines of communication between borrower and lender.
Typical covenants for real estate related loans are the Loan to Value Ratio (LTV), the debt service coverage ratio (DSCR) and Interest Service Coverage Ratio (ISCR).
Covenants can potentially have negative consequences as well. As the creditor is imposing restrictions on how the debtor should conduct business, the debtor's economic freedom is restricted. This may lead to decreased efficiency. When a covenant is broken and additional equity should be contributed, the debtor might not be able to provide it or at least not adequately. This results in making the whole loan due; a resulting fire sale may lead to high write-offs on the debtor's books.
Covenants can be financial, information, ownership, affirmative, negative or positive covenants. Often, the breach of any covenant gives the lender the right to call the loan or collect interest at a higher rate.
References
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loan covenant
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Loan Covenant - Defintion, Types, Why They're Used
What is a Loan Covenant? Loan covenants are a series of small, independent agreements made between a debtor (borrower) and a creditor (lender). Loan covenants expressly outline …
Loan covenant - Wikipedia
A loan covenant is a condition in a commercial loan or bond issue that requires the borrower to fulfill certain conditions or which forbids the borrower from undertaking certain actions, or …
What Is a Covenant? Definition, Meaning, Types, and Examples - Investopedia
Jun 28, 2023 · A debt covenant arises when an entity works with a financial institution to take out a loan. To secure the loan, the entity must agree to meet certain criteria, not perform certain …
What Is a Covenant in Finance? Definition, Types, and Key …
Feb 1, 2025 · Breaching a covenant tied to a $1 million loan could trigger defaults on other loans, even if they are otherwise performing. This can result in accelerated repayment demands or …
What Are Loan Covenants? A Guide to Financial Covenants | Truist
Loan covenants ensure that a borrower’s financial performance supports the profitability and cash flow needed to repay the loan. They serve as risk management safeguards for the lender, but …
Debt Covenants - How They Work, List of 10 Most Common Covenants
Oct 23, 2024 · Debt covenants are loan agreement clauses listing certain requirements the borrower must meet to maintain the loan. They are a tool for lenders to manage risk because …
Understanding Loan Covenants and Their Financial Impact
Jan 19, 2025 · Loan covenants are essential elements of financing agreements, designed to protect lenders by imposing specific conditions on borrowers. These stipulations influence a …
Loan Covenants: The Do's and Don'ts to Avoid Breaching Terms
Jun 20, 2024 · Loan covenants are a set of individual agreements established between a borrower (debtor) and a lender (creditor) that explicitly define the actions and behaviors that a …
Understanding Loan Covenants: A Guide for Borrowers
Loan covenants are conditions in a loan agreement that borrowers must follow throughout the loan term. They help lenders ensure the borrower stays financially disciplined and capable of …
Debt Covenants: How They Work (Plus Prime Examples) - Fast …
May 25, 2022 · Debt covenants are agreements between a business and creditor that the company will operate within the rules established by the lender as a condition for receiving a …