Explanation of Loan Covenants

Loan covenants are a condition that must be met by a borrower in order to avoid defaulting on a loan. Lenders use loan covenants as a way to gain additional control over loans. Here are the basics of loan covenants.

Loan Covenants

Loan covenants are commonly used with many different types of loans. With this type of covenant, a lender is going to set forth specific rules that must be followed in order for the loan to remain valid. These conditions are not specific terms of the loan such as the interest rate or the payment amount. However, they are important, and they have to be met in order for the loan to stay in good standing with the lender. 

Reasoning

Lenders could utilize loan covenants for a number of reasons. For example, a lender might decide to include a loan covenant in order maintain the quality of the loan. They might also want to preserve the equity in a home with a mortgage loan. They might also use a loan covenant in order to make sure that the borrower maintains a certain financial standing.

Insurance

One of the most common loan covenants is that the lender is going to require insurance on the property that is being borrowed against. For example, if you are getting a mortgage, you are going to have to have homeowner's insurance on the house. This is done so that the lender is going to be protected if anything bad happens to the property. Without hazard insurance, the house could be completely destroyed in a fire. If that happens, the borrower is not going to have a house to live in and will not have insurance to repay the lender. In that case, he would basically be making a payment on a house in which he can no longer reside. In most cases, the individual would simply allow the loan to go into default, and it would hurt the lender. 

Taxes

Another common loan covenant is when a lender requires the borrower to make tax payments on the property. This is very common with mortgage loans. In order to guarantee this, many lenders offer escrow accounts that will take the money from the monthly mortgage payment. The escrow company will then use the money to pay the taxes and insurance every year.

Financial Ratios

Some loans also have covenants that deal with financial ratios. With these covenants, the borrower is going to have to keep his financial situation within certain ratios in order to keep the loan in good standing. This makes sure that the homeowner does not change anything significant about his financial situation while he is in the middle of a loan repayment.

Key Person Insurance

With commercial loans, companies are often required to insurance on important individuals within the company. This is going to insure the life of a key person such as the owner of the company. This will make sure that the operation of the business is not negatively affected by the death of one individual.

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