What is loan covenant?

Loan covenants set the rules a borrower must follow while a loan is outstanding. Affirmative covenants require actions, such as delivering financial statements, maintaining insurance and paying taxes. Negative covenants restrict actions, such as taking on more debt, paying dividends, selling assets or changing ownership without consent. Financial covenants require specific results, such as a minimum debt service coverage ratio or maximum leverage.

Covenants act as an early warning system. Financial maintenance covenants are tested at regular intervals, usually quarterly or annually, while incurrence covenants are tested only when the borrower takes a specified action. A breach is an event of default that gives the lender the right to renegotiate terms, charge fees, require more collateral or, in serious cases, accelerate the loan.

Covenants protect the lender only if they are tracked. Missed financial statements, tests calculated with the wrong definitions and breaches that go unnoticed are common operational failures. Covenants set too loosely provide little warning, while covenants set too tightly can trigger defaults over minor fluctuations and lead to repeated waivers.