Quick overview

Loan covenants are conditions in a loan contract that tell the borrower what they must do, what they must not do, and what financial metrics they must maintain. Lenders use covenants to limit risk, get early warning of deteriorating credit, and protect collateral value. Borrowers who know how covenants are written and measured can reduce surprises, negotiate better terms, and keep access to credit.

Types of loan covenants (practical definitions)

  • Affirmative covenants: Actions the borrower must take. Common examples include maintaining insurance on collateral, delivering audited financial statements on a set schedule, paying taxes when due, and keeping corporate status (e.g., good standing with state authorities).
  • Negative covenants: Actions the borrower must avoid. Typical prohibitions include taking on additional secured debt, selling key assets, making dividend payments above a cap, or granting liens without lender consent.
  • Financial covenants: Numeric tests measured at regular intervals. Examples are maximum leverage ratios (debt/EBITDA), minimum interest coverage ratios (EBIT/interest expense), minimum net worth, and minimum current ratios. These are often the most litigated and negotiated clauses because they depend on accounting definitions and timing.

Financial covenants may be structured as either maintenance tests (measured periodically, e.g., quarterly) or incurrence tests (triggered only when taking a specific action, like incurring new debt).

Why covenants matter (consequences and mechanics)

Covenants matter because they translate risk-management preferences into enforceable contract terms. Consequences of breaching a covenant include:

  • Technical default: The borrower remains current on payments but violates a covenant. The lender may seek remedies such as fees, higher interest, or additional reporting.
  • Event of default: Some covenant breaches are designated as events of default, allowing the lender to accelerate the loan, demand immediate repayment, foreclose on collateral, or seek a receiver.
  • Waivers and forbearance: Lenders often cure covenant breaches with a formal waiver or forbearance agreement—usually for a fee and with corrective actions or amended covenant levels.

Typical lender responses escalate: notice to borrower → opportunity to cure (if contract allows) → waiver or amendment → enforcement (acceleration, collateral remedies). The specific sequence depends on the loan documents and negotiation history.

Sources for common practice and consumer-focused guidance include the Consumer Financial Protection Bureau and standard financial education resources (CFPB, Investopedia).

Real-world examples and common clauses (practical illustrations)

  • A commercial real estate loan may require a debt service coverage ratio (DSCR) above a set threshold. If DSCR falls below the covenant, the lender can require additional reserves or call a default. See how related CRE protections are documented in reserve accounts like debt service reserve accounts (example: Understanding Debt Service Reserve Accounts in Commercial Real Estate Loans).
  • A growth-stage company might have an incurrence covenant that prevents it from issuing new secured debt without lender consent. Violating that covenant could block future fundraising or produce cross-defaults with other lenders.

In my practice advising middle-market businesses, I’ve seen three frequent pain points: unclear measurement definitions (e.g., which adjustments to EBITDA are allowed), mismatched testing dates and cash flow cycles, and overly broad negative covenants that prevent routine corporate actions. Clear definitions and negotiated carve-outs solve many of these problems.

How lenders and borrowers negotiate covenants

Borrowers with stronger credit or collateral can push for fewer or looser covenants, higher thresholds, or incurrence-based tests instead of maintenance tests. Lenders may insist on stricter maintenance covenants when risk is concentrated (e.g., single-asset loans).

Negotiation levers include:

  • Carve-outs and baskets: Allow limited actions (like a small amount of additional debt or permitted asset sales) without triggering covenants.
  • Measurement definitions: Carefully define EBITDA, revenue recognition, and pro forma adjustments to avoid disputes.
  • Testing frequency and look-back periods: Quarterly tests with specified measurement dates reduce ambiguity.

For guidance on how changes to cash flow affect covenant compliance, see our article on how income spikes or drops affect loan renewals and financial covenants.

Typical lender remedies and borrower options after a breach

When a covenant breach occurs, parties commonly pursue one of these paths:

  1. Cure within a contractual period (if allowed) — pay overdue amounts, restore ratios, or post additional collateral.
  2. Obtain a waiver — the lender agrees not to treat the breach as an event of default for a defined period, often for a fee and stricter reporting.
  3. Amend the loan — change covenant thresholds, measurement rules, or testing dates to reflect business realities.
  4. Forbearance — a temporary pause on enforcement while the borrower follows a remediation plan.
  5. Enforcement — lender accelerates the loan, forecloses on collateral, or pursues judgment. This last step is more common in secured commercial lending when other remedies fail. See “Legal Remedies for Breach of Loan Agreement: Steps for Borrowers and Lenders” for detailed options and procedural considerations.

Practical checklist to manage covenant compliance

  • Inventory all covenants and their measurement dates in one spreadsheet.
  • Assign owners for each covenant (CFO, controller, external accountant) and set automated alerts for upcoming tests.
  • Reconcile accounting definitions monthly to the loan agreement to spot divergent treatments early (e.g., timing of revenue recognition, what counts as EBITDA adjustments).
  • Maintain a rolling 12-month cash flow forecast tied to covenant tests.
  • Communicate early with lenders if a breach looks likely—proactive dialogue often yields waivers or amendments at lower cost than emergency fixes.

Frequently misunderstood points

  • Payment performance ≠ covenant compliance. You can be current on payments but still be in technical default for covenant violations.
  • Covenants are negotiable, especially at origination or during restructurings. Don’t assume terms are immutable.
  • Accounting definitions matter. Two parties can compute the same ratio differently; the loan agreement controls the calculation.

When to call a lawyer or advisor

Call legal counsel or your financial advisor before signing documents with complex covenants, and immediately if a breach occurs. Legal remedies and priorities (e.g., intercreditor rights, lien perfection) can materially affect outcomes—particularly in multi-lender capital structures. For steps to take after a breach, our guide on legal remedies for breach of loan agreement may be helpful.

Internal resources (related FinHelp articles)

Bottom line

Loan covenants are powerful tools that allocate risk between borrower and lender. When well-drafted and actively managed, they reduce surprises and preserve credit access. When ignored or poorly understood, they can lead to costly technical defaults and loss of control. Review covenants with your finance and legal advisers, track compliance proactively, and negotiate changes early if business conditions evolve.

Disclaimer: This article is educational only and does not constitute legal or financial advice. For advice tailored to your circumstances, consult a qualified attorney or financial advisor.