A debt covenant is a clause in a loan agreement that requires the borrower to fulfill certain conditions or forbids the borrower from undertaking certain actions. These covenants are used by lenders to protect their investments and ensure that the borrower remains financially stable enough to repay the debt. There are two main types of debt covenants:
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Affirmative (Positive) Covenants: These are the things that the borrower must do while the loan is outstanding. Examples include maintaining certain financial ratios (like a debt-to-equity ratio), providing financial statements to the lender, maintaining business insurance, and paying taxes and other debts on time.
Negative Covenants: These restrict the borrower from undertaking certain actions. Common examples include restrictions on incurring additional debt, paying dividends, selling assets, or making significant changes to the business without the lender’s consent.
The purpose of these covenants is to provide lenders with some control over the actions of the borrower that might affect its financial health or the value of the collateral. If a borrower violates a debt covenant, it can result in a default on the loan, even if all payments are being made on time. This could lead to penalties, an increase in interest rates, or the lender demanding immediate repayment of the loan.
Debt covenants are common in both personal and commercial lending and vary widely depending on the specifics of the loan, the lender, and the borrower’s situation.
Keep in mind the bank may not want to default on the loan or take the businesses assets in certain environments (like office building in 2023).
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