What is the purpose of loan covenants?

The purpose of loan covenants is fundamentally to restrict the borrower from taking certain actions that could negatively impact their creditworthiness. This mechanism serves to protect the lender's investment by ensuring that the borrower maintains a certain level of financial health and stability throughout the term of the loan.

Covenants typically include specific criteria, such as financial ratios that must be maintained, limits on additional borrowing, or requirements to provide regular financial reports. By adhering to these covenants, borrowers demonstrate their commitment to maintaining their financial condition, which mitigates risk for the lender. Therefore, when a lender imposes covenants, they do so with the intent of safeguarding their interests and limiting potential risks that could arise from the borrower's management decisions or changing economic conditions.