“What is a Loan Covenant?”

 

A “covenant” is a popular phrase in a Biblical context, but it has its place in the financial industry as well, particularly with loans. Borrowing and lending money requires a certain level of trust in that both sides have faith that the other will come through with what they are promising. The lender will provide the money and the borrower will eventually pay them back.

 

That is the simple way of describing loan covenants. However, there are more details to go over.

 

Understanding covenants

 

A covenant in a financial, as well as legal, context is a promise made with an indenture or any other formal debt agreement. It guarantees that certain thresholds will be met or certain activities will or will not be performed. In finance, covenants are often related to financial contract terms, including a loan document or bond issue that establishes the limits at which the borrower can do more lending.

 

A loan covenant illustrates an agreement specifying the terms and conditions of loan policies between a lender and a borrower. The agreement provides lenders with some leeway in granting loans while at the same time protecting their lending position. Likewise, due to the regulations’ transparency, borrowers receive the straightforward expectations of the lenders.

 

A violation of a covenant will normally lead to a default on the loan being declared, the loan being called, or other penalties being applied. The loan agreement’s legal provision for the loan to be “called” is known as the “Acceleration Clause.” It illustrates that when the buyer defaults, all future payments due under the loan are essentially accelerated and considered to be payable right away.

 

The three types

 

There are three types of agreements in loan covenants: affirmative loan covenants, negative loan covenants, and financial loan covenants.

 

  • Affirmative loan covenants are reminders to borrowers that they need to carry out expressed activities to preserve their business operation. This will in turn create a steady financial performance. The result of a breach in this covenant is the borrower being in default of their obligations. Consequently, the borrower may be granted a grace period that will allow them to fix the violations, or the lender may proclaim it a default, thus demanding full repayment.
  • In the case of negative loan covenants, lenders should create a firewall to protect the borrower’s major financial and ownership decisions. To do this, they must ensure that they own rights to certain notifications (ex. capital structure modifications). This will streamline the borrower’s credibility and lower the chances of defaulting. This is why businesses or borrowers should have a proper understanding of a loan covenant’s terms.
  • Financial loan covenants inspect whether the borrower is reaching or is close to obtaining the targets of the lender’s estimates. The closer to the targets means more satisfaction for the lender. Likewise, the farther away from the projections, the higher the chances of the borrower defaulting. So, to be safe, lenders may present restrictions on the amount of credit the borrower can access.