The Devil Is in the Details, Pay Attention to Loan Covenants

We all know that borrowing money is a great way to pay for a home, business, auto or education while building credit at the same time.

It’s also important that we encourage and teach our kids and grandkids to take advantage of what banks and other lending institutions have to offer as a means to building wealth. But we also need to teach them to pay attention to the details of any loan agreements they sign, particularly the covenants.

There are many types of covenants, which are used to structure loans and set guardrails for the use of the money. Here’s a snapshot of the most common:

Quantitative covenants set standards for financial measures—such as cash flow, debt level and business strength—that give a lender confidence in a borrower’s ability to repay a loan. Typical measures include debt-to-equity, cash-to-assets, and interest coverage ratios.

Qualitative covenants specify information that borrowers must provide, like quarterly financial statements or tax reports. These covenants also restrict actions you can take, like taking on more debt or selling assets without the lender’s consent.

Standard loan covenants outline criteria that are part and parcel of lending but still must be stipulated in the credit agreement to be legally enforceable. An example would be requiring the borrower to pay the principal and interest on specific due dates.

Nonstandard loan covenants, typical in commercial lending, address characteristics related to the borrower. They include requiring the borrower to supply accounts receivable lists or monthly compliance certificates.

Financial loan covenants seek to ensure that a borrower maintains adequate financial health to repay the loan. They may restrict financial decisions, like debt-to-equity ratios or maximum capital expenditure requirements.

Nonfinancial loan covenants protect a lender’s interest beyond financial health. They may restrict a company’s ability to change leadership, or merge with another company or acquire one.