A covenant in loan agreements that requires borrowers to repay the full principal amount upon breach of contract or failure to meet certain requirements
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An acceleration clause is a covenant in loan agreements that requires borrowers to repay the full principal amount upon breach of contract or failure to meet certain requirements set by the lender. Acceleration clauses are most prevalent in the real estate industry, where they protect the lender when the borrower defaults on interest payments or some other debt covenant. The number of missed payments or breached obligations that are acceptable are determined in the loan agreement during negotiations.
Triggers for Acceleration Clauses
The following are the circumstances in which acceleration clauses can be triggered:
1. Failure to meet interest payments
Interest payments are determined by the interest rate that a lender charges a borrower. Interest payments are required over fixed time intervals (usually every month). Failure to meet interest payment requirements can result in an acceleration clause being triggered. However, the threshold for the number of missed payments before which the clause is triggered varies based on the loan agreement.
2. Failure to meet mortgage payments
Since principal loan amounts are typically large, repayment takes place through interest payments and mortgage payments over fixed time intervals. Failure to meet the partial mortgage payments may result in the activation of an acceleration clause.
3. Due-on-sale clauses
A “due-on-sale” clause is a provision found in loan agreements, which allows the lender to demand full repayment of the principal amount if the borrower sells the property that is mortgaged for the loan. In a way, due-on-sale clauses are very similar to acceleration clauses and can be used to trigger an accelerated loan repayment in case the property is sold.
4. Breach of debt covenants
Debt covenants are restrictions placed by lenders on loan agreements in order to align the interests of the lender and the borrower. The covenants usually limit the actions of the borrower and reduce the risk that the lender faces by setting certain rules within which the borrower must act.
If the borrower breaches the restrictions, the lender can trigger an accelerated clause and demand full repayment. More information on the types of debt covenants can be found in CFI’s article on Debt Covenants.
Practical Example – Acceleration Clause
Suppose Dreamland Inc. entered into a contract to purchase six acres of land from Graceland Corp. for $1,000,000. The $1,000,000 is to be paid in annual installments of $200,000 over the next five years. Suppose Dreamland completes the first three payments but fails to pay the fourth installment on time.
With an acceleration clause, Graceland can now demand the full $400,000 immediately. If the $400,000 cannot be paid in the given time frame, Graceland can take possession of the land without returning the $600,000 that it already received.
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