A defeasance clause is a loan term commonly found in contracts where a person takes a mortgage on a house or a commercial real estate loan. It ensures that, once the loan is paid back, the lender transfers the title and ownership of the property to the borrower. But defeasance clauses occur in other types of loan contracts as well, as the term defease means you have met your obligations to the contract, making it null and void.
Where Defeasance Clauses Are Used
This is why defeasance clauses can be applied to other situations, including small business loans like:
- Commercial real estate purchases where the borrower substitutes other assets of equal value, like machinery, as collateral instead of the property purchase.
- Bonds where a single bond is used to purchase all outstanding corporate bonds or swapping a bond for other assets and securities.
- Providing a way to pay off a loan early without having to incur any additional penalties.
Knowing how a defeasance clause works can help you go to the signing table prepared to negotiate, as it is one of the terms of a loan you can have a say in when you have good credit and are a low-risk borrower.
Examples of How You Can Use a Defeasance Clause
One example of a non-mortgage defeasance clause could be replacing the items you currently have for collateral with new assets that are equal in value or meet the lender’s collateral requirements. This way, you can shift assets you need for other purposes, like taking a new loan from a different lender when the new lender requires the assets you originally leveraged on the property loan.
Another example is if you issue bonds or invest in bonds. The issuer can deposit assets and securities into an escrow account to “pay off” the debt owed to the bond owners. By doing this, the bond issuer can clear the debt off their records, which may help raise their business credit score and make them more appealing as a low-risk borrower when taking a business loan, or when they want to avoid prepayment penalties.
Using a defeasement clause for bonds allows a business owner to lower their interest rate on the debt if rates have dropped since the initial issuing. This is also a way to lower their levels of debt and make the company more attractive to investors, as their financial and debt ratios will be improved. Defeasance clauses can also work as an alternative to “call” a bond and pay off the debt without penalty.
Defeasement clauses mostly apply to mortgages for real estate loans in both commercial and consumer situations, but they can be a valuable asset for business owners who need to take a loan, want to attract investors, or need to improve their financial standing by making their financial ratios stronger.
