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Types of Loan Covenants

Loan covenants may be categorized in a variety of ways. They include:

Standard vs. Non-Standard

Standard loan covenants are generally outlined in a boilerplate format, meaning they’re standard for all borrowers. 

Standard loan covenants outline circumstances or behaviors that are often taken for granted but must still be stipulated in a credit agreement for the legal enforceability of the contract. Examples include:

• The borrower must make principal + interest payments when due.
• The borrower may not sell any physical assets underpinning the credit exposure without repaying the credit in full. (meaning a borrower cannot sell the car for which they took out a vehicle loan without repaying it in full, as that vehicle is collateral security).

Non-standard loan covenants are designed based on particular characteristics or risks related to a credit request or a borrower. 

Non-standard loan covenants are typical with commercial lending since business operations and financial results are more complex than personal lending. Examples include:

• The borrower must provide an aged accounts receivable listing and a compliance certificate monthly.
• The borrower must not pay any dividends to common shareholders without the express written consent of the lender.

Positive vs. Negative

Positive loan covenants (often called affirmative covenants) outline what a borrower must do. These are typically worded as:

• The borrower must… 
• The borrower will…

Negative loan covenants stipulate actions that the borrower must NOT do. Negative covenants are usually worded as:

• The borrower must not…
• The borrower will not…

Both standard and non-standard loan covenants can be worded as either as a positive or as a negative.

Financial vs. Non-Financial

Financial loan covenants are explicitly related to a borrower’s financial metrics. They should be designed based on specific risks inherent in the credit structure or particular risks the borrower presents. Examples of financial covenants are:

• The (commercial) borrower must maintain a minimum debt service coverage ratio (DSC) of X : 1.
• The (personal) borrower must maintain a minimum total debt service ratio (TDS) of not less than Y : 1.

Non-financial covenants include a wide variety of expected behaviors or circumstances that are not specific to the borrower’s financial measures. Examples include:

• The borrower will provide accountant-prepared corporate financial statements within X days of its fiscal year-end.
• The borrower is not permitted to change ownership or control without the express written consent of the lender.

How and Why are Covenants Used?

Creditors extend loans to generate interest income. Part of the calculation is to ensure the full repayment of principal, so to the extent that it’s possible, a lender will always seek to exert any influence on that borrower to help ensure financial well-being. This is where loan covenants come in. 

By expressly requiring or restricting specific actions or circumstances, loan covenants serve two primary purposes. The first is to help align incentives between the borrower and the lender; the second is to mitigate transaction (or borrower) specific risks. 

Both of these processes improve the likelihood of full loan repayment.

Aligning Incentives

An example in commercial lending is where a management team may wish to distribute a large proportion of company earnings to shareholders through dividend payments. The lender would rather see that cash retained within the corporation to provide a cash buffer or, perhaps, to repay some of its outstanding credit. 

This misalignment of incentives can be managed by limiting or restricting dividends or by requiring that financial covenant calculations be net of dividend payments.

The most basic illustration of this concept is a loan agreement where strict repayment dates are not expressly outlined in the credit agreement. What incentive would a borrower have to make payments on time? 

The concept of aligning incentives is a crucial one.

Mitigating Risks

Loan covenants are also used to mitigate specific risks. Think about a borrower taking on high leverage (or gearing) to make an acquisition. It’s in the lender’s best interest to have that borrower deleverage as quickly as possible to bring its leverage ratios back to long-term expectations or industry norms.

Potential Loan Covenant Pitfalls

Loan covenants should only be employed when specific incentives need better alignment or when mitigating a particular risk. Loan covenants that are too restrictive can have ramifications for the lender. These include, but are not limited to:

Setting a borrower up for failure

This is when a lender forces a covenant on a borrower that is unrealistic or not likely to be attainable. Consider the earlier example of a company that borrows heavily to acquire another company – it’s normal for the debt-to-equity (D:E) ratio to balloon in the acquisition year.

Let’s say the ratio is 3.5 : 1 in the acquisition year, but the lender generally prefers 2 :1 or below. Many lenders may institute a going-forward covenant of 2 : 1, as illustrated below:

However, it’s unlikely the borrower can realistically accomplish this by the first fiscal year-end post-acquisition. An alternative might be the use of a stepped covenant, like below:

Stepping covenants is a more prudent strategy to align incentives and to de-risk the relationship without the risk of setting the borrower up for almost inevitable failure. Using steps like this allows the borrower to gradually return to a normal range without undue stress on company management.

Middle office headaches

Another risk of overusing covenants is that someone from the middle office at the financial institution must track and action each covenant at the end of each reporting period. This administrative burden can increase headcount and cause potential compliance issues since each breached covenant must be documented and overseen appropriately.

Perceived competitiveness in the marketplace

All other factors being equal, most borrowers prefer fewer and less restrictive loan covenants. If a financial institution consistently puts proposals in front of clients and prospects that overuse loan covenants (relative to competitors), they may lose some opportunities.

Covenant Breaches

When a loan covenant is violated, it’s often referred to as a covenant breach. 

Since loan covenants are part of the credit agreement between a borrower and a lender, a covenant breach is considered an event of debt default. These can be financial defaults (like a delinquent payment) or technical defaults (like late reporting).

All covenant breaches must be reviewed by a risk manager and documented in writing by the lender since they violate the credit agreement. But while all loan covenants are important and legally binding, not all covenant breaches are created equally. 

For example, late financial reporting may be an issue with the client’s accountant that could be resolved within a few days or a week. Similarly, a client that must adhere to a DSC covenant of 1.25 : 1 (but that reports a DSC ratio of 1.23 : 1) is unlikely to receive an accelerated repayment notice from the bank.

Fraudulent financial results presented to a lender, however, would be considered a severe technical default that would likely have immediate and serious legal consequences for the borrower.

Other Resources

Thank you for reading CFI’s guide to Loan Covenant. To keep advancing your career, the additional CFI resources below will be useful:

The term collateral refers to an asset that a lender accepts as security for a loan. Collateral may take the form of real estate or other kinds of assets, depending on the purpose of the loan. The collateral acts as a form of protection for the lender. That is, if the borrower defaults on their loan payments, the lender can seize the collateral and sell it to recoup some or all of its losses.

• Collateral is an item of value used to secure a loan.
• Collateral minimizes the risk for lenders.
• If a borrower defaults on the loan, the lender can seize the collateral and sell it to recoup its losses.
• Mortgages and car loans are two types of collateralized loans.
• Other personal assets, such as a savings or investment account, can be used to secure a collateralized personal loan.

Before a lender issues you a loan, it wants to know that you have the ability to repay it. That's why many of them require some form of security. This security is called collateral which minimizes the risk for lenders. It helps to ensure that the borrower keeps up with their financial obligation. In the event that the borrower does default, the lender can seize the collateral and sell it, applying the money it gets to the unpaid portion of the loan. The lender can choose to pursue legal action against the borrower to recoup any balance remaining.

As mentioned above, collateral can take many forms. It normally relates to the nature of the loan, so a mortgage is collateralized by the home, while the collateral for a car loan is the vehicle in question. Other nonspecific, personal loans can be collateralized by other assets. For instance, a secured credit card may be secured by a cash deposit for the same amount of the credit limit—$500 for a $500 credit limit.

Loans secured by collateral are typically available at substantially lower interest rates than unsecured loans. A lender's claim to a borrower's collateral is called a lien—a legal right or claim against an asset to satisfy a debt. The borrower has a compelling reason to repay the loan on time because if they default, they stand to lose their home or other assets pledged as collateral.

The nature of the collateral is often predetermined by the loan type. When you take out a mortgage, your home becomes the collateral. If you take out a car loan, then the car is the collateral for the loan. The types of collateral that lenders commonly accept include cars—only if they are paid off in full—bank savings deposits, and investment accounts. Retirement accounts are not usually accepted as collateral.

You also may use future paychecks as collateral for very short-term loans, and not just from payday lenders. Traditional banks offer such loans, usually for terms no longer than a couple of weeks. These short-term loans are an option in a genuine emergency, but even then, you should read the fine print carefully and compare rates.

Another type of borrowing is the collateralized personal loan, in which the borrower offers an item of value as security for a loan. The value of the collateral must meet or exceed the amount being loaned. If you are considering a collateralized personal loan, your best choice for a lender is probably a financial institution that you already do business with, especially if your collateral is your savings account. If you already have a relationship with the bank, that bank would be more inclined to approve the loan, and you are more apt to get a decent rate for it.

Use a financial institution with which you already have a relationship if you're considering a collateralized personal loan.

A mortgage is a loan in which the house is the collateral. If the homeowner stops paying the mortgage for at least 120 days, the loan servicer can begin legal proceedings which can lead to the lender eventually taking possession of the house through foreclosure. Once the property is transferred to the lender, it can be sold to repay the remaining principal on the loan.

A home may also function as collateral on a second mortgage or home equity line of credit (HELOC). In this case, the amount of the loan will not exceed the available equity. For example, if a home is valued at $200,000, and $125,000 remains on the primary mortgage, a second mortgage or HELOC will be available only for as much as $75,000.

Collateralized loans are also a factor in margin trading. An investor borrows money from a broker to buy shares, using the balance in the investor's brokerage account as collateral. The loan increases the number of shares the investor can buy, thus multiplying the potential gains if the shares increase in value. But the risks are also multiplied. If the shares decrease in value, the broker demands payment of the difference. In that case, the account serves as collateral if the borrower fails to cover the loss.