What is a breach of covenant and how to avoid it

Commitments are 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 that one of the parties involved in the contract has broken those promises in some way.

In the case of automobiles, covenants can be conditions attached to financing the purchase of the vehicle or form part of the loan agreement between a lender and you as the borrower.

What is a breach of engagement?

Covenants are promises or stipulations that are part of written contracts, often related to real, tangible property such as a vehicle. If one of the parties involved in the contract fails to comply with any part of these conditions or stipulations, then this is considered a breach of the covenant.

In the case of an auto loan – the financing associated with the purchase of a vehicle – the loan agreement between the lender and the borrower may include requirements regarding the specific terms of the debt. Covenants are requirements or conditions imposed by the lender and borrowers must agree to these conditions in order to finalize financing.

Because loans are a contract between a lender and a borrower, any breach of that contract constitutes a breach of covenant and may even result in a lawsuit.

Parties to Breaches of Covenants

There are different types of restrictive covenants, including positive and negative restrictive covenants and standard and non-standard restrictive covenants.

Positive Commitments versus Negative Commitments

Positive covenants generally include a variety of obligations that a borrower must meet in order to stay in compliance with a contract and for the agreement to remain in place.

However, covenants are designed to prevent borrowers from engaging in high-risk actions. These types of covenants generally require borrowers to obtain prior approval for any action that may be deemed risky.

Standard clauses and non-standard clauses

Standard covenants are generally the same for all borrowers. An example of a standard covenant might be that a borrower must make principal repayments on a loan and must make those repayments by their due date.

In contrast, non-standard covenants are unique to a particular borrower and their personal circumstances.

How a Covenant Breach Affects a Borrower

There are a range of consequences for breaching a covenant. They could include:

  • Pay financial compensation for breach of an undertaking
  • Pay a fee or penalty charged by the lender
  • Increase in the interest rate on your loan
  • Revision of the contractual agreement
  • Termination of the agreement

In some cases, in order to maintain the agreement after a breach of covenant, you may even be required to provide some form of additional security.

The bottom line

Covenants are terms that are part of a contract, especially debt contracts such as car loans or financing. When signing a contract, be sure to carefully review all the terms and conditions of the agreement so that you fully understand them and stay compliant.

In the event of breach of a commitment, you risk having to pay penalties, a higher interest rate or even to see the contract terminated.

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