Common Loan Covenants and How They Impact Borrowers

How do loan covenants affect borrowers?

Loan covenants are conditions embedded in loan contracts that require borrowers to meet specified financial metrics, perform certain actions, or refrain from specified activities during the loan term. Lenders use covenants to reduce risk and monitor borrowers between scheduled financial reviews. For borrowers, covenants are double-edged: they can preserve access to capital and encourage disciplined management but also reduce operational flexibility and trigger costly remedies when breached.

In my practice advising small businesses and middle-market firms, I’ve seen covenants shape decisions ranging from capital expenditures to hiring. A covenant that looks minor in a term sheet can become a major constraint once cash flow tightens, so reading and planning for covenant compliance is essential.

Types of loan covenants (and what they mean for you)

• Financial covenants: These set minimum or maximum financial ratios or thresholds the borrower must maintain, such as Debt Service Coverage Ratio (DSCR), debt-to-equity, interest coverage, or minimum liquidity (cash or current ratio). If your business runs seasonally, a static covenant tied to a quarterly snapshot can create short-term breaches even when annual performance is solid.

• Affirmative (positive) covenants: Actions the borrower must take, for example filing timely tax returns, maintaining insurance, providing audited or periodic financial statements, or using loan proceeds for stated purposes. These often carry reporting deadlines; missing paperwork can trigger technical defaults.

• Negative covenants: Restrictions on actions like taking on additional debt, selling collateral or key assets, making large investments, paying dividends, or changing ownership without lender consent. Negative covenants protect lender collateral and credit position but can block strategic moves like acquisitions.

• Maintenance vs. incurrence covenants: Maintenance covenants require you to stay within a ratio continuously (e.g., maintain DSCR > 1.25 each quarter). Incurrence covenants only apply when you take a specific action (e.g., you can’t incur more debt unless a test passes). Maintenance covenants are usually harder for borrowers to manage.

Common covenant metrics explained

• Debt Service Coverage Ratio (DSCR): Cash available for debt payments divided by debt service (principal + interest). Lenders typically set a minimum (e.g., 1.1–1.5 for many commercial loans). A DSCR below the minimum signals difficulty meeting payments and can trigger a breach.

• Leverage ratios (debt-to-EBITDA or debt-to-equity): These cap how much debt you can carry relative to earnings or capital structure.

• Current ratio or minimum liquidity: Ensures short-term obligations can be met.

Note: Specific numeric thresholds vary by lender, borrower risk profile, and industry; always confirm the exact covenant language in your loan documents.

Sources on commonly used covenant metrics include the Consumer Financial Protection Bureau (CFPB) and the Small Business Administration, which discuss lender practices and borrower protections (see: https://www.consumerfinance.gov and https://www.sba.gov).

Real consequences of covenant breaches

Breach consequences range from mild to severe:

• Technical default notice: Lenders typically issue a notice and demand a cure within a contractual cure period. Many loan agreements allow a short window to correct the issue.

• Waivers and amendments: Lenders may grant waivers or renegotiate terms (often for a fee or a higher rate) if the borrower requests proactively and the lender judges the problem temporary.

• Remedies and acceleration: Persistent breaches can let the lender accelerate the loan, increase interest rates, require immediate repayment, foreclose on collateral, or enforce cross-default provisions that affect other loans.

• Covenant drift and rolling defaults: Missing one covenant can impair access to future credit, strain lender relationships, and even trigger defaults in related agreements (cross-default clauses).

See our deeper coverage of triggers and next steps: “What Triggers a Loan Covenant Breach and What Happens Next” (FinHelp) for practical steps and timelines: https://finhelp.io/glossary/what-triggers-a-loan-covenant-breach-and-what-happens-next/.

Practical, step-by-step lender-facing strategies I use with clients

1. Read every covenant and define the test. Identify whether it’s a maintenance or incurrence covenant and the reporting cadence.

2. Model covenant tests in worst-case scenarios. Build a 12-month rolling forecast that highlights when a covenant might fail under lower revenue or higher costs.

3. Establish covenant monitoring and alerts. Use a simple spreadsheet or KPI dashboard that flags covenant values at least monthly.

4. Prioritize liquidity and contingency plans. Keep a reserve or committed credit line sized to cure shortfalls during seasonal dips.

5. Communicate early and constructively. If a shortfall is likely, inform the lender before missing the test. Lenders often prefer proactive dialogue and structured remedies; I’ve seen waivers granted when borrowers showed realistic recovery plans.

6. Negotiate upfront. Seek flexible language on cure periods, permitted deviations, and carve-outs for seasonality, working capital swings, or acquisitions.

7. Use waivers strategically. If you need a waiver, provide supporting forecasts, recent financials, and a clear repayment or recovery plan. Expect a fee, additional security, or higher rates.

Negotiation points borrowers should request

• Clear cure periods and grace periods for reporting defaults.
• Carve-outs for capital expenditures and seasonality.
• Step-down or seasonal averaging for ratio tests.
• Clear definitions (e.g., ‘‘EBITDA’’ vs. ‘‘Adjusted EBITDA’’) to avoid future disputes.
• Limits on cross-defaults and caps on default interest rates.

In my experience, lenders willing to negotiate these terms are often more relationship-driven and easier to work with in stressed periods.

Operational and tax considerations

Loan covenants can affect operational choices—delay investments, limit dividends, or require asset maintenance. Some covenants also have tax implications: for example, changes in ownership or asset sales can trigger tax events. Always run covenant-related strategic moves past your accountant or tax advisor. The IRS offers guidance on tax consequences of sales and reorganizations (https://www.irs.gov), and the CFPB explains borrower rights and lender practices (https://www.consumerfinance.gov).

Who is most affected

• Small businesses: Often face tighter covenants or more restrictive negative covenants because of higher lender perceived risk. See our small-business-focused guide for practical expectations: “Loan Covenants for Small Business Owners: What to Expect” (FinHelp): https://finhelp.io/glossary/loan-covenants-for-small-business-owners-what-to-expect/.

• Middle-market and large corporates: Typically negotiate more sophisticated, customized covenant packages. Public companies may face additional scrutiny from investors.

• Individuals: Less common for consumer loans but can appear in home-equity lines, business-backed personal loans, and some mortgage modifications.

Common mistakes borrowers make

• Treating covenants as boilerplate. Minor wording changes can have big consequences.

• Failing to test covenant compliance under stress scenarios.

• Waiting until after a breach to talk to the lender.

• Ignoring reporting deadlines—technical defaults often arise from missing a required financial statement, not from poor ratios.

Remedies, waivers, and refinancing options

• Waiver: A temporary, lender-granted permission letting you remain in the current loan despite a covenant breach, often for a fee.

• Amendment: A negotiated change to the loan document that alters covenant thresholds, reporting, or other terms.

• Refinancing: Replacing the loan with new debt, possibly with different covenants—useful when a covenant problem is persistent or the lender relationship is strained.

• For distressed borrowers: Consider short-term relief like forbearance or restructure offers; consult a bankruptcy attorney only if default remedies are imminent. Early communication gives the best chance for workable solutions.

When to get professional help

Engage a commercial loan attorney and an experienced CFO or financial advisor before signing or if you face a likely breach. In my practice, outside advisors help craft negotiation letters, build credible forecasts, and structure amendments lenders will accept.

Checklist before signing any loan with covenants

• Confirm each covenant type and the exact calculation method.
• Build a covenant-compliance forecast including worst-case scenarios.
• Clarify reporting frequency and required statements.
• Ask for sample waiver language and typical fees.
• Negotiate cure periods and seasonal averaging where appropriate.

Further reading and internal resources

• Small-business-focused expectations: “Loan Covenants for Small Business Owners: What to Expect” — https://finhelp.io/glossary/loan-covenants-for-small-business-owners-what-to-expect/
• Covenant breach triggers and remedies: “What Triggers a Loan Covenant Breach and What Happens Next” — https://finhelp.io/glossary/what-triggers-a-loan-covenant-breach-and-what-happens-next/
• For lenders’ perspective on DSCR: “How Debt-Service Coverage Ratio (DSCR) Affects Commercial Loan Approval” — https://finhelp.io/glossary/how-debt-service-coverage-ratio-dscr-affects-commercial-loan-approval/

Authoritative sources: Consumer Financial Protection Bureau (CFPB) — https://www.consumerfinance.gov; Small Business Administration (SBA) — https://www.sba.gov; Internal Revenue Service (IRS) — https://www.irs.gov. These sources describe lender practices, borrower protections, and tax consequences.

Professional disclaimer: This article is educational and does not constitute legal, tax, or financial advice. For tailored guidance, consult a qualified attorney, tax professional, or licensed financial advisor.