What is a Loan Covenant?

Malcolm Tatum

A loan covenant is a provision within a commercial loan that places certain requirements on the borrower that are somewhat more restrictive than the standard loan term agreement. Typically, a covenant of this type takes the form of something that the borrower is not allowed to do until the balance of the loan has been paid in full, or at least until certain conditions placed within the text of the agreement have been fulfilled. Lenders sometimes make use of this type of restrictive provision when extending loans to businesses.

Man climbing a rope
Man climbing a rope

An example of a loan covenant within a commercial loan extended to a company may include restricting rate increases to the salaries of company executives. This means that for the duration of the loan, the business agrees to not offer pay increases to those executives. A similar approach would be to limit or forego any type of bonuses for mangers and executives until at least a specific portion of the loan has been retired. The idea behind these restrictions is to minimize the risk taken on by the lender, since funds generated by the borrower are less likely to be diverted to these other uses, which in turn helps to increase the chances that the loan will be paid off in a timely manner.

In some instances, a lender may later choose to waive a loan covenant. This is most likely to occur when the financial circumstances of the borrower undergoes some sort of radical change. For example, if the company began to generate revenue due to an unanticipated influx of new customers, and maintained that level of revenue generation over several accounting periods, the lender may decide that a particular loan covenant is no longer necessary to protect his or her interests. At that point, the borrower is notified that the specific covenant recorded in a specified point in the loan contract is waived and is no longer binding.

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Should a borrower choose to engage in an action that is expressly forbidden by a loan covenant, the lender usually has the right to call the loan due immediately. Should the borrower fail to respond to this early call, the lender is then able to declare the debt to be in default, and take whatever actions are allowed legally to collect the outstanding debt. There is also the potential for the lender to refrain from calling the outstanding balance of the loan due, choosing to instead apply specific penalties or charges for the breach of the contract terms.

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