What are Debt Covenants And Why Do We Rarely Use Them?

A debt covenant is a restriction that lenders put on lending agreements to limit the actions of borrowers. They’re a type of agreement between the lender and borrower, and you might have also heard them called banking covenants or financial covenants.

What’s the purpose of these debt covenants? They’re primarily used to align the interests of the lender and the borrower, but they’re not very commonly used. A ‘covenant’ is used with any type of banking agreement, and it’s typically part of the fine print you sign when you agree to a loan, credit card, etc.

However, a debt covenant goes beyond a traditional contract, so there’s a lot to understand before you agree to this type of relationship. In this guide, we’ll share what debt covenants are and why we rarely use them.

What Exactly Is a Debt Covenant?

First, what is a debt covenant? Also known as a banking covenant or loan covenant, this is a type of agreement between a borrower and a lender. These are established within financial contracts, usually with loans and bonds.

Under a debt covenant, a borrower is either obligated or forbidden to undertake specific actions. Debt covenants might sound intimidating, but they’re commonly used for business agreements. This type of agreement is so the lender can ensure the borrower maintains their company in a specific way, typically in the best interest of the lender.

Ultimately, these debt covenants are used so the lender can manage borrowers in a way that’s beneficial to them. Because they want to protect their loan, the debt covenant acts as a guard that keeps the business from taking any risky actions that could affect its ability to pay back the loan.

How Do Debt Covenants Work?

Now that you understand the basic principles of a debt covenant, how do these work? These types of agreements can either be positive or negative. When a debt covenant is positive, the company must do something to maintain the agreement. Conversely, if it’s negative, the company is forbidden from certain actions.

These types of agreements can be restrictive for many businesses. Because they limit the businesses ability to take creative or ‘risky’ action, they’re not a common choice for borrowers. Most debt covenants control the businesses operations, like maintaining a specific financial growth rate or having a certain amount of cash on hand.

When a company runs into a problem, like a decrease in business, this could breach the debt covenant with the lender. When this happens, they’re in violation. The business has a specific number of days to solve the problem (typically around a month). After this time frame, the lender can take action to handle the situation. There might be penalties, like late fees or a need to pay the loan in full immediately.

Why You Should Avoid Debt Covenants

With all of these restrictions in mind, it’s easy to see why so many businesses and individuals avoid debt covenants. They’re overly restrictive, and they can cause trouble unintentionally if there are any unexpected changes to business.

No matter the current standing of the borrower, we can’t ever predict the future. Because these debt covenants put the lender in a position of control, they’re not recommended in most situations. In some cases, a breach of the debt covenant is unavoidable. It’s normal and expected for businesses, particularly small business, to rise and fall over time.

Ultimately, a debt covenant is a risky type of investment. Though it might be a good fit for stable, secure businesses, it’s typically not recommended for most borrowers. Luckily, there are other alternatives that are less restrictive such as:

  • Unsecured business loan: An unsecured business loan is a short-term loan, and it doesn’t use any collateral. You qualify based on your creditworthiness, and these typically have short-term repayment terms of up to 12 months.
  • Business finance: This type of traditional loan is done through online brokers or traditional banks, and they’re used to support all aspects of starting and running a business.
  • Bad credit business loans: No matter your credit, you can usually access bad credit business loans. While these will come with a higher interest rate, they can be a smart option if you have a repayment plan.
  • Business credit card” A business credit card is a way to make the most of your business cash flow while also taking advantage of credit card perks and features.

Understand Your Loan Agreements

Before you agree to any type of debt, whether business or personal, always make sure you know what you’re agreeing to. While a debt covenant might sound like a sound investment, these come with a lot of unexpected restrictions. For growing businesses, having these restrictions can hold back your success.

When in doubt, rely on the expertise of the Debt Buster’s team. With over 15 years of experience helping people of all backgrounds manage their debt and financial futures, we’ll work with you to determine the best path forward. Contact our team today on 1300 368 322 to get started.

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