What is a breach of covenant?
Key takeaways
- A covenant serves as a written contract between two parties, like a lender and borrower, that one must follow.
- If that covenant is broken, it is known as a breach of covenant and can result in a lawsuit.
- There are a few primary types of covenants, including positive or negative and standard and non-standard.
Covenants are a part of a written contract and often involve promises or stipulations to do something — or even a promise not to do something in the future. When a breach of covenant occurs, it means one of the parties involved in the contract has violated those promises in some way.
In the case of automobiles, the covenants may be terms or conditions tied to the financing for the vehicle purchase or part of the loan agreement between a lender and you as the borrower.
What is a breach of covenant?
Covenants are promises or stipulations that are part of written contracts. Many times, these are related to property, such as a vehicle. But if one of the parties involved in the contract fails to meet the agreed-upon conditions, it is considered a breach of covenant.
In the case of an auto loan, the loan agreement between the lender and borrower may include requirements surrounding the specific terms of the debt. The covenants are requirements or conditions imposed by the lender, and the borrowers must agree to those conditions to finalize financing.
Because loans are a contract between a lender and a borrower, any contract violation constitutes a breach of covenant and may even result in a lawsuit.
Types of covenants
There are various types of covenants, including positive and negative covenants and standard and non-standard covenants.
Positive vs. negative covenants
Positive covenants typically include a variety of obligations that a borrower must meet to remain in compliance with a contract and for the deal to remain in place. One example auto loan borrowers may encounter maintaining a strong credit score.
Negative covenants, however, are designed to prevent borrowers from engaging in high-risk actions. These types of covenants typically require borrowers to obtain advance approval for any actions that may be deemed risky.
Standard vs. non-standard covenants
Standard covenants are generally the same for all borrowers. An example of a standard covenant might be that a borrower must make principal payments on a loan and must make those payments by their due date.
By contrast, non-standard covenants are unique to a particular borrower and that borrower’s circumstances.
How a breach of covenant affects a borrower
There are a range of possible consequences for breach of covenant, though not all are common among auto loans:
- Paying financial compensation for violating a covenant
- Paying a fee or penalty charged by the lender
- Increased interest rate on your loan
- Revision of the contractual agreement
- Termination of the agreement
In some cases, to maintain the agreement after a breach of covenant, you may even be required to provide some form of additional collateral. For auto loan borrowers, a breach could result in the lender demanding early repayment of the loan, repossession of the vehicle or the enforcement of additional fees.
The bottom line
Covenants are conditions of a contract, particularly debt contracts such as auto loans or financing. When signing a contract, be sure to review all stipulations and conditions of the agreement carefully so that you fully understand them and can remain in compliance.
To avoid breaching your contract, you must effectively manage your auto loan. This includes following your budget and paying on time and in full.
When a breach of covenant occurs, you risk paying penalties, a higher interest rate or even having the contract terminated altogether.
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