Loan Covenant

A loan covenant is a promise the borrower makes in the loan agreement about how it will run its business or property while the loan is outstanding. Covenants give the lender early warning and some control before a problem turns into missed payments.

There are three main types:

• Affirmative covenants are things the borrower must do. Examples: send annual financial statements and tax returns, keep insurance, pay taxes and keep the collateral in good repair.
• Negative covenants are things the borrower must not do without the lender's consent. Examples: take on more debt, sell major assets, change ownership or pay large distributions.
• Financial covenants are measurable tests. Common ones are a minimum debt service coverage ratio (DSCR), a maximum loan-to-value (LTV) ratio, a maximum debt-to-income ratio for the business, or a minimum level of cash.

Here is how a test works. A loan requires a DSCR of at least 1.25, tested each year. If the borrower's cash available for debt service is $250,000 and its annual debt payments are $200,000, the DSCR is 1.25 and the test is met. If cash flow drops to $220,000, the DSCR falls to 1.10 and the covenant is breached.

Why it matters for lenders

Covenants are often the first sign that a loan is weakening. A breach lets the lender step in early: ask for more information, raise the risk rating, require a paydown or extra collateral, or renegotiate terms. Many agreements let the lender charge a default interest rate or call the loan after an uncured breach.

Covenants only help if someone tests them. US bank examiners look at whether lenders track covenants, spot violations and handle waivers with discipline. Failing to catch breaches, or waiving them over and over without a reason on file, weakens the lender's position and can draw criticism in an exam.

Mission lenders face covenants from the other side as well. Their own investors and funders often set covenants on delinquency, concentration or net assets.

How it works in practice

A commercial lender has 200 loans with annual financial covenants. Each loan record lists its covenants with the formula, the limit, the test date and the documents needed. Sixty days after each borrower's fiscal year end, the system requests statements.

When documents arrive, an analyst uses financial spreading to put the numbers into a standard format, runs the tests and records pass or fail. A breach goes to the relationship manager and credit officer, who decide on a waiver, an amendment or a stronger response. Each decision is approved and saved on the loan.

With a spreadsheet tracker, tests slip, documents go missing and waivers are granted by email. A year later, nobody can show what was decided or why.