What is Technical Default
A technical default is a deficiency in a loan agreement that arises from a failure to uphold certain aspects of the loan terms other than the regularly scheduled payments. Technical default indicates that the borrower may be in financial trouble, and can trigger an increase in a loan's interest rate, foreclosure or other negative events. This may be viewed independently of normal default risk.
BREAKING DOWN Technical Default
Technical defaults can be based on a variety of factors. Lenders will outline provisions that can lead to technical default in their loan agreements. Borrowers are required to uphold all provisions of the loan agreement throughout the life of the loan. Making regularly scheduled payments is the most tangible loan provision since it can be easily evaluated at each installment when the lender is required to make a payment. Borrowers should also maintain awareness of other loan provisions that may lead to technical default. Depending on the terms of the loan, some lenders may offer grace periods allowing borrowers to improve certain aspects in technical default. This is especially common if a borrower has no missed payments or other delinquencies.
Technical Default Provisions
Provisions leading to technical default can be customized by the lender to include a wide array of factors. In standard loans some of the most common technical default provisions can include maintenance of qualifying ratios. For personal loans and credit cards this would refer to a borrower’s total debt-to-income ratio. For mortgage loans this could refer to maintenance of the housing expense ratio and debt-to-income ratio.
Residential and Commercial Mortgage Loans
Residential and commercial real estate mortgage loans will also include additional provisions that could lead to technical default. For both residential and commercial borrowers, property taxes and insurance premiums may be a loan contract term that must be maintained by the real estate owner. Provisions often associated with a commercial real estate loan can include building maintenance, building repairs and tenant occupancy. For example, a real estate co-op could go into technical default if it has failed to keep up with building maintenance and repairs, even though the mortgage is paid up.
Companies also are often subject to maintaining certain operational ratios when engaging in a business loan agreement. Business loan agreement may include provisions specifically for a company’s current ratio, quick ratio, debt-to-equity and working capital levels. For example, a corporation could go into technical default if it falls short of meeting promised debt-to-equity detailed in its loan agreement, even if it has been making all loan payments as agreed.