What is an Acceleration Clause?
The term “acceleration clause” refers to a contract provision that permits a lender to speed up the repayment of a loan if one or more than one pre-decided condition is breached. In other words, the acceleration clause outlines the various situations under which a lender can enforce repayment of a loan well before its scheduled repayment. The acceleration clause is also popularly known as an “acceleration covenant.”
The acceleration clause is typically contingent on on-time payment, and failure on the part of the borrower to comply allows a lender to demand repayment of the subject loan before the expiry of the scheduled terms. These clauses are usually associated with mortgage loans, where they mitigate the risk of the borrower’s default. These clauses are mostly invoked in the case of payment delinquencies, but they can also be structured to incorporate other conditions as well. In most cases, an acceleration clause forces the borrower to repay the outstanding loan balance right away in case any of the terms are breached.
Practical Example of Acceleration Clause
Now, let us look at an example for understanding the concept of an acceleration clause. Let us assume that David entered into a contract to purchase a commercial real estate property from Barney for $500,000, which has to be repaid in 10 equal annual installments of $50,000. Suppose, after paying the first seven installments, David fails to pay the 8th instalment on time resulting in default and triggering the acceleration clause.
With the acceleration clause, Barney can now demand repayment of the remaining $150,000 immediately. In case David is unable to pay the outstanding balance in the given time frame, then Barney can take back possession of the commercial real estate property without returning the $350,000 that he already received from David.
How to Invoke Acceleration Clause?
It protects the lenders from the risk of loan default, especially mortgage and real estate loans. The following are some of the circumstances under which these clauses can be invoked:
- Failure to make interest payments: Interest payments have to be paid at a fixed interval of time (usually monthly). Failure to meet interest payments on a number of occasions can result in an acceleration clause being triggered.
- Failure to meet mortgage payments: The mortgage payments include principal repayment and interest payments and, hence, are usually large. Therefore, the inability to pay the mortgage payments in full may also trigger the acceleration clause.
- Breach of debt covenants: Covenants are restrictions placed on a borrower by a lender to reduce the risk of any hostile borrower action that can adversely impact the borrower’s debt serviceability.
- Due-on-sale clauses: This is a provision of a loan contract that allows the lenders to demand payment of the outstanding balance in full if the borrower decides to sell the mortgaged property.
Options After Acceleration Clause
In case of failure to meet mortgage payments, the borrower might end up with an acceleration clause being enforced. However, there are still some options that the borrower can consider to come out of the situation.
- Create a repayment plan: Request reinstatement of the mortgage and bid the amount that needs to be paid to catch up on the missed payments and cover any other associated fees. Once the shortfall is paid off, the borrower can start with the regular repayments.
- Accept foreclosure: During foreclosure, the borrower has the option to catch up on the payments, refinance the loan, or go for a short sale to prevent the foreclosure.
Considerations for Acceleration Clause
Before enforcing an acceleration clause, a lender needs to consider the following factors:
- Interest payable: In the case of mortgage acceleration, the borrower is only responsible to pay the interest owed up to that point along with the outstanding principal balance of the mortgage. In such a case, the borrower doesn’t need to pay the future interest payments, and the lender loses out on potential interest income.
- Risk: Typically, a borrower misses payments when he/ she doesn’t have money. So, there is a high probability that if the acceleration clause is triggered, the borrower won’t be able to make the full payment in the given shorter time frame inflicting significant losses to the lender.
- Prepayment penalty: If the lender triggers the acceleration clause, which means that the borrower didn’t initiate the prepayment. In such a case, the borrower doesn’t need to pay any prepayment penalty usually associated with paying off a loan before tenure.
Some of the major advantages of an acceleration clause are as follows:
- First, it clearly defines the condition under which the loan should be considered to be bad debt and makes monitoring easy for the lender.
- It helps a lender recover bad debts, which is a common event in the lending business. In this way, it significantly reduces the risk of losing out on the lent money.
- Once the full payment as per the clause is made, the borrower is relieved of the future interest payments.
Some of the major disadvantages are mentioned below:
- From the perspective of borrowers, it is an unfavorable clause as it compels them to pay a large sum of money at very short notice.
- The terms and conditions captured in an acceleration clause can be overwhelming to understand for a layman.
- It usually results in the borrower losing the mortgaged property in addition to the money that has been already paid for the subject property.
Some of the key takeaways of the article are:
- It is a contract provision that allows the lender to enforce repayment of the unpaid borrowed sum in full if the borrower fails to fulfil some of the pre-decided conditions of the contract.
- These contract provisions reduce lending risks and protect the lenders.
- These clauses are mostly found in real estate lending and mortgage loans.
This is a guide to Acceleration Clause. Here we also discuss the introduction and types of agency problems along with advantages and disadvantages. You may also have a look at the following articles to learn more –