An event of default occurs when a borrower breaches a credit agreement and is considered to have defaulted on their debt. Default generally occurs when you fail to repay loans according to the terms in the promissory note with your lender. Credit agreements or promissory notes specify what happens in the event of default.
Definition and Examples of Event of Default
When you borrow money, such as a personal loan or car loan, you take on certain obligations. These are outlined in your loan or credit agreement. Credit agreements specify which breaches of those obligations will constitute an event of default.
For example, let’s say you took out a mortgage to buy a new home. The credit agreement you received from your lender outlined the events of default, such as nonpayment of amounts due. If you were to stop making your mortgage payments, your lender would deem your loan to be in default.
An event of default clause could specify that if you fail to make payments, the creditor is entitled to take the title or place a lien on the property acting as collateral for the loan.
How Event of Default Works
Credit agreements, such as mortgage records, specify what constitutes an event of default. Typically, an event of default can happen when there is failure to make payments, failure to pay required fees, or insolvency or receivership.
Credit agreements also specify the consequences of an event of default, which include all of the rights, powers, and remedies outlined in the loan document—or those permitted by law. This could involve:
- The loss of a home if the loan was a mortgage loan
- The loss of assets guaranteeing the loan if it is a secured loan
- A demand for immediate repayment of the outstanding loan balance
- Interest and penalties charged on the unpaid balance
A creditor may require you to obtain the signatures of co-owners of a property being offered as collateral. This ensures that the creditor can carry out the consequences of default.
Event of Default Clauses
Event of default clauses in loan documents protect borrowers and lenders by specifying when a borrower is in breach of a loan agreement and what the consequences of that breach entail.
An event of default clause in a credit agreement can help you as a borrower understand what types of actions could trigger consequences, such as nonpayment or insolvency. This can reduce the chances of you engaging in those actions, which have an adverse consequence on the lender.
An event of default clause also allows you to understand the consequences of an event of default so you are aware of what to expect if you can't pay your loan or some other event of default occurs. It also gives lenders the right to impose consequences, such as seizure of collateral, which can help the lender recover unpaid funds when there is a risk that loan obligations will not be fulfilled.
If you default on a loan, you will likely face some undesirable consequences. For example, your credit score may decrease, which can make it more difficult to obtain a home or auto loan in the future.
However, event of default clauses are a crucial part of ensuring the availability of credit. Lenders need some legal means by which to make borrowers repay debt to limit their risk.
During the 2020 recession, many retailers struggled financially. One such example was department store J.C. Penney Co. In April 2020, the company began exploring bankruptcy, according to sources who spoke with Reuters, before declining to make a $12 million interest payment due to its lenders. At that point, a 30-day grace period went into effect.
If at the end of that grace period, J.C. Penney Co. still had not made the payment, this would have triggered an event of default per the credit agreement with its lenders. However, the retailer was able to make the necessary payment that was due in May 2020. Therefore, the event of default was avoided.
- An event of default occurs when a borrower violates the terms of a loan agreement.
- Common consequences of an event of default include late fees, a requirement to repay the outstanding loan balance, or seizure of collateral guaranteeing a secured loan.
- Clauses within events of default allow borrowers to understand what constitutes a breach of the loan agreement and what the consequences are for such a breach.
- Lenders are protected by events of default, which give them a legal remedy if the borrower doesn't comply with loan agreements.