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What Is a Negative Pledge?

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  • Written By: Mary McMahon
  • Edited By: O. Wallace
  • Last Modified Date: 05 October 2014
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A negative pledge is a term in a borrowing agreement which prohibits the borrower from taking on additional debt without consent from the original lender. This is designed to protect the lender from “dilution of security,” in which it would be unable to recover its debt in the event of a default. These types of clauses are used in a variety of agreements related to borrowing and lending money and they are one reason why people should review the terms with care before borrowing funds.

One classic reason to use a negative pledge is a large unsecured loan. Lenders who make unsecured loans are aware that if the borrower takes out another loan and pledges assets as security, the new lender can seize those assets in the event of a default, leaving the unsecured lender with less chance of recovering the funds it is owed. Likewise, lenders want to prevent situations in which people pledge the same assets twice.

This type of clause is also known as a covenant of equal coverage clause. When a negative pledge clause is included in the terms of a loan, the borrower may not create situations in which later lenders get priority in the event of a default. If the borrower does want to take out another loan, it can be negotiated with the lender and the lender can decide whether or not the borrower represents a security risk.

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Lenders which have a priority claim on assets owned by the borrower can include a negative pledge to make it clear that the borrower cannot repledge those assets or pledge assets in such a way that the security of the original loan would be compromised. For example, when someone takes out a mortgage, the bank has a priority claim on the house in the event of a default. Pledging the house against another loan would dilute the security of the original mortgage and for this reason the bank would likely include a negative pledge agreement in the mortgage paperwork.

The documentation which accompanies a loan can be lengthy, and many borrowers are often tempted to skim over it. However, it is strongly advisable to read the material over with care and to ask a lawyer for assistance if there are clauses which are unclear. When a negative pledge is included in a loan, an attorney can discuss the implications of the clause with the borrower and the borrower can make a decision about whether or not to take on the debt on the basis of how the clause might affect his or her activities.

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JessicaLynn
Post 3

This is just another argument for reading the fine print on any contract you sign! I swear, all my friends are sick of me saying this, but if you are going to sign a contract, you should read it first. And read every word, don't just skim!

I personally think it's even worth paying a lawyer to look at some kinds of contracts, loan contracts included. That way you can make sure you know exactly what you're signing, so you don't breach your contract later on.

indemnifyme
Post 2

@KaBoom - A negative pledge definitely makes sense in the context of a mortgage. Your house is already collateral on your mortgage loan, so how could it be collateral on something else?

I think a negative pledge also makes sense on unsecured loans too. Unsecured loans are extremely risky for a bank, because the customer doesn't put up any kind of collateral. So if the customer defaults on the loan, the bank may or may not be able to recover their money. I can understand a bank not wanting an unsecured loan customer to get into any more debt.

KaBoom
Post 1

My friend is in the process of buying a house, and I was helping her go through her papers for her mortgage. It actually does include something like a negative pledge. She isn't allowed to pledge her house as collateral on any other loan while she's still paying off the mortgage.

I've never heard of this before, because I'm not a homeowner and I've never taken out a loan, but I totally understand why a bank would do this. Why would the bank want to put themselves in a risky situation if you were to default on the mortgage? If your house was already gone as collateral on another loan, the bank wouldn't really have a way to recoup their money.

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