Most business loans contain something called “covenants” which can become a major headache for a small business, and is something every business owners needs to be aware of. When you take out a loan or business line of credit from a bank or other financial institution, loan covenants are put in place by the lender. These covenants are in place to protect lenders but can cause adverse conditions for business owners, such as recall of a loan.
The problem comes when you violate a commercial loan covenant without even knowing it and find that you’re in default of the loan and facing penalties or other negative consequences. In some cases the bank will even have the right to recall the loan and demand payment in full when you violate a loan covenant. Most small businesses can’t afford to repay a credit line in full and end up in the uncomfortable situation of having to borrow at a higher interest rate to satisfy the loan recall.
Lenders use covenants to manage risk. But to borrower’s, especially small businesses with limited financial resources, they can be troublesome.
For example, let’s say you own a small flower shop and you open a $100,000 business line of credit with a local bank. When applying for the loan all you’re really concerned about is getting access to the money your business needs to get up and running, and getting it at a low interest rate. After you’re approved, you’re so excited that you don’t pay as close attention as you should to the fine print and the covenants of the loan. But you trust the bank due to a working relationship you’ve had with the for year, and you accept the terms of the loan and get access to the funds.
A year goes by and you’ve accessed more than half of your credit line but you need more money for a small greenhouse section you’re adding to your shop. So you tap into the rest of your credit line and zero it out to complete the project. Unfortunately, one of the covenants on your loan stipulated that if you zero out the credit line the bank has the right to recall the loan in its entirety. The bank contacts you and to your surprise, they want payment in full. Obviously you don’t have $100,000 laying around to pay them back so you’re in a tricky financial situation that was easily avoidable.
In this situation you’d be forced to refinance the balance you owe at a much higher rate or find a new lender. Had you paid more attention to the loan covenants you could have avoided this situation simply by leaving a small amount of available credit in your business line.
The are other situations where covenants can come into play as well, such as the requirement of liability insurance and more. The bottom line is that every business owner must take the time to know the details of the agreement when they borrow money, or hire a lawyer or financial advisor to spell out all the terms of the loan before they sign on the dotted line.
The problem comes when you violate a commercial loan covenant without even knowing it and find that you’re in default of the loan and facing penalties or other negative consequences. In some cases the bank will even have the right to recall the loan and demand payment in full when you violate a loan covenant. Most small businesses can’t afford to repay a credit line in full and end up in the uncomfortable situation of having to borrow at a higher interest rate to satisfy the loan recall.
Lenders use covenants to manage risk. But to borrower’s, especially small businesses with limited financial resources, they can be troublesome.
For example, let’s say you own a small flower shop and you open a $100,000 business line of credit with a local bank. When applying for the loan all you’re really concerned about is getting access to the money your business needs to get up and running, and getting it at a low interest rate. After you’re approved, you’re so excited that you don’t pay as close attention as you should to the fine print and the covenants of the loan. But you trust the bank due to a working relationship you’ve had with the for year, and you accept the terms of the loan and get access to the funds.
A year goes by and you’ve accessed more than half of your credit line but you need more money for a small greenhouse section you’re adding to your shop. So you tap into the rest of your credit line and zero it out to complete the project. Unfortunately, one of the covenants on your loan stipulated that if you zero out the credit line the bank has the right to recall the loan in its entirety. The bank contacts you and to your surprise, they want payment in full. Obviously you don’t have $100,000 laying around to pay them back so you’re in a tricky financial situation that was easily avoidable.
In this situation you’d be forced to refinance the balance you owe at a much higher rate or find a new lender. Had you paid more attention to the loan covenants you could have avoided this situation simply by leaving a small amount of available credit in your business line.
The are other situations where covenants can come into play as well, such as the requirement of liability insurance and more. The bottom line is that every business owner must take the time to know the details of the agreement when they borrow money, or hire a lawyer or financial advisor to spell out all the terms of the loan before they sign on the dotted line.
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