What Is Technical Default?
A technical default is a deficiency in a loan agreement that arises from a failure to uphold an aspect of the loan terms (other than the regularly scheduled payments). Technical default indicates that the borrower may be in financial trouble, and may trigger an increase in a loan's interest rate, foreclosure, or other negative events.
- A technical default is a deficiency in a loan agreement that arises from a failure to uphold an aspect of the loan terms (other than the regularly scheduled payments).
- Lenders will typically outline provisions that can lead to technical default in their loan agreements.
- Some of the most common technical default provisions include the maintenance of qualifying ratios: for example, a borrower’s total debt-to-income ratio or the maintenance of the housing expense ratio.
Understanding Technical Default
Technical defaults can be based on a variety of factors. Lenders will typically 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 their loan.
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 may refer to a borrower’s total debt-to-income ratio. For mortgage loans, this could refer to the maintenance of the housing expense ratio and debt-to-income ratio.
Making regularly scheduled payments is the most recognizable loan provision since it can be easily evaluated at each installment when the lender is required to make a payment. However, borrowers should be aware of any other loan provisions that can lead to a technical default.
Depending on the terms of the loan, some lenders may offer grace periods that allow borrowers to improve certain aspects that may have led to the technical default. This is especially common if a borrower has had no missed payments in the past or other types of delinquencies on their account.
Types of Technical Default
Residential and Commercial Real Estate Mortgage Loans
Residential and commercial real estate mortgage loans may also include additional provisions that could potentially lead to technical default. For both residential and commercial borrowers, property taxes and insurance premiums may be a term in the loan contract 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 it is fulfilling its mortgage payments).
Companies may also be subject to maintaining certain operational ratios when engaging in a business loan agreement. Business loan agreements may include provisions specifically for a company’s current ratio, quick ratio, debt-to-equity ratio, and working capital levels. For example, a corporation could go into technical default if it falls short of meeting the promised debt-to-equity ratio that is detailed in its loan agreement (even if it has been making all loan payments as agreed).