A technical default occurs when a borrower fails to fulfill specific terms and conditions of their loan agreement with a lender other than the payment arrangements.
Learn some of the ways a technical default can happen, and how it can lead to negative consequences for the borrower.
Definitions and Examples of a Technical Default
Most people would probably consider that making payments on time is enough to keep their loan in good standing. However, another way to default on your loan despite making timely payments is known as a technical default, which occurs when you violate parts of a contract unrelated to monthly payments.
Depending on the type of loan, lenders write covenants into the loan agreement that outline what terms and conditions may lead to a technical default.
- Alternate name: Non-monetary default
One example of a technical default happens when a borrower is not maintaining homeowners insurance for a mortgage loan. This could place the homeowner at risk for foreclosure.
Technical defaults are often mentioned in relation to business lending, but also apply to consumer lending.
Lenders must make the covenant details clear before the loan agreement is signed. This ensures borrowers fully understand that there are additional obligations they must fulfill to avoid a technical default.
How a Technical Default Works
Prior to initiating a loan agreement, lenders create loan terms or “covenants” to help lower the risk of a technical default by the borrower. A covenant can be either affirmative or negative, and it spells out all the terms and conditions of the loan contract other than the payments. A technical default can happen if a borrower breaches either an affirmative or negative covenant at any point during the life of the loan.
An affirmative covenant is considered a positive covenant, in which the borrower promises to adhere to the specified terms of the loan agreement. An example of an affirmative (positive) covenant is when a borrower and a mortgage lender agree that the borrower will reside in the property until the loan is paid back in full.
A negative covenant, on the other hand, typically mandates that the borrower avoids doing something that would violate the loan agreement. It is often found in business agreements. For example, a company may have a new hire sign a contract that prevents them from revealing company secrets to a competitor.
If a technical default occurs based on a contract’s covenant, lenders can remedy the situation by calling back the loan, freezing credit lines, increasing interest rates or fees, and even (in some cases) having a say in the corporate decision-making of a business.
In some instances, a work-out agreement between the borrower and lender may be used to avert a technical default. Regardless, the best way to avoid a technical default is to ask your lender about the actions that could trigger one.
Types of Technical Default
Technical defaults typically occur with mortgages and business loans.
Mortgage and Real Estate Loans
Provisions regarding technical defaults are contained in mortgage loans. Some terms that typically apply to commercial and residential borrowers may include maintaining property taxes and insurance premiums. Failure to comply with these conditions could lead to a technical default by the borrower.
Covenants for business loans can be customized to fit the unique nature and activities of a borrower's business. Several factors may be used to determine what actions a lender may take against the borrower if a technical default occurs, including a business's finances, the performance and stability of the company, and the relationship with the lender.
Technical Default vs. Monetary Default
A monetary default is a default that’s usually related to a monthly payment. An example of a monetary default is how federal student loans will go into default if the borrower hasn’t made a payment in more than 270 days.
A non-monetary default will occur if a borrower fails to uphold any loan agreement terms that do not include money. These types of non-monetary defaults can consist of a business failing to keep operating expenses at a required level or failure to submit required annual reports.
- A technical default occurs when there is a breach in a loan agreement other than payment arrangements.
- Covenants are clauses that outline the terms and conditions of a loan agreement that can lead to a technical default if violated.
- A technical default can be avoided when a borrower fully comprehends and abides by all the provisions of a loan contract.