Covenant: Meaning, Types, and Benefits

This post was originally published on June 5th, 2023, and updated on February 11th, 2025.

‍

When you hear the word "covenant," the first thing that probably comes to mind is its biblical meaning, an ancient pledge. While this is one meaning, a covenant is far more than a religious term. Covenants are legally binding contracts that specify particular duties or limitations between parties in law, finance, and real estate. It functions as a method for enforcing responsibilities and constraints under various contracts. Legally speaking, a covenant is enforceable. Non-compliance may result in fines, legal action, or contract violations.

Different types of covenants

Positive covenant

Also known as affirmative covenants, positive covenants require one or both parties to take certain actions or perform specific duties. These are typically obligations that an individual should follow during the agreement. For example, a property owner should adhere to maintaining a particular standard of landscaping in a community. Positive covenants ensure that all parties remain engaged and fulfill their responsibilities.

Negative covenant

A negative covenant, also called a restrictive covenant, imposes restrictions on specific actions to prevent parties from doing things that jeopardize the interests of other parties to the agreement. A good example is real estate, wherein a covenant may prohibit the construction of high-rise buildings in a residential area to preserve the neighborhood's homey atmosphere. The main goal of negative covenants is to protect the stability and integrity of agreements.

Bilateral covenant

A bilateral covenant is an agreement in which both parties should fulfill specific terms and conditions. Contracts often contain these covenants where parties exchange mutual promises. For example, in a real estate contract, the buyer agrees to make payments while the seller agrees to transfer ownership. The obligations of both parties are legally enforceable.

Unilateral covenant

Unlike a bilateral covenant, a unilateral covenant is a one-sided promise, wherein only one party is bound to act or refrain from acting. You often see unilateral covenants in wills, charitable donations, and legal guarantees. For example, a developer might promise to maintain a public park without requiring any action from the community.

Conditional covenant

A conditional covenant requires a specific action or event to occur before utilization. Parties add these covenants to loan agreements, real estate deals, and business contracts. For example, a lender may demand that a borrower maintain a particular credit score to be eligible for a reduced interest rate. If the borrower fails to meet these conditions, the parties involved can void or adjust the covenant as needed.

Unconditional Covenant

An unconditional covenant in a contract is a commitment that is not dependent on any particular conditions, and the terms of the agreement bind both parties without fail. A covenant that requires no future action from either party after the performance is termed an unconditional covenant. Such an alliance is absolute and non-negotiable. Since it requires no future action after fulfillment, being unable to adhere can lead to penalties, such as fines or legal consequences. 

Financial covenant

A financial covenant is commonly included in loan agreements because they are essential in regulating a borrower's spending habits. This type of covenant ensures the borrower's ongoing financial stability and ability to repay the loan. By establishing these requirements, lending companies can protect their investments while encouraging clients to manage their money wisely.

Real estate covenant

A real estate covenant controls property development, usage, and maintenance. Developers usually enforce the homeowners to maintain consistency and guarantee the community's aesthetic appeal. For instance, a real estate covenant might forbid property owners from making exterior changes to their homes that deviate from the neighborhood's architectural style.

Employment covenant

An employment covenant usually includes non-disclosure, non-compete, and non-solicitation agreements. They protect the employer's sensitive data and commercial interests. A non-compete agreement, for example, may prohibit a former employee from working with competitors or similar company backgrounds within a specific period.

Benefits of covenants

Reduce the risks

Covenants, especially those in financial contracts, assist lending companies in reducing risk by ensuring that borrowers follow specific financial guidelines. They may require borrowers to keep a healthy debt-to-equity ratio or have sufficient liquidity. By doing so, lenders get early notice of potential financial difficulties, enabling them to take corrective action.

Improve transparency

Covenants define each party's responsibilities, limitations, and expectations, eliminating confusion in agreements. This level of transparency ensures that everyone's responsibilities and duties are readily understood and prevents disputes.

Protect interests

Covenants aim to protect the interests of all involved parties by ensuring that actions committed by one party are not harmful to the other. Restrictions on land usage, for instance, guarantee that every resident maintains the community's value and character in a real estate covenant.

Improve loan terms

By adhering to covenants, lenders can feel reassured when borrowers exhibit consistency and financial discipline. Since they believe lending is less dangerous, lenders may provide better terms, like lower interest rates or higher credit limits.

Maintain standards

Covenants are vital in real estate to help maintain standards and uniformity in a community or property. To guarantee that the neighborhood retains its visual appeal and desirability throughout time, they could, for instance, forbid specific alterations to homes or commercial establishments.

Build trust

Covenants create accountability and commitment among involved parties, which helps build trust. Individuals actively build a collaborative environment when they take ownership of their commitments.

How to write covenants

A covenant must be specific and clear to be effective and enforceable. The steps below will help you through the process.

Step 1: Establish the goal

The initial step in putting a covenant in writing is to identify its intent. What are the parties expecting the covenant to accomplish? Is it to restrict an action, such as disallowing further borrowing, or to enforce an obligation, like maintaining a financial ratio? The covenant's goal will influence its structure.

Step 2: Use clear and accurate language

When writing a covenant, it is crucial to use clear and accurate language to avoid confusion. Don't use technical terms or jargon; explain the terms clearly. The covenant may be unenforceable if any party is unclear about the conditions or limitations. Clearly defining the necessary steps and outlining any consequences for non-compliance is crucial.

Step 3: Identify all the involved parties

Every covenant needs to outline all parties involved and their rights and obligations. For instance, the financial covenant should specify the responsibilities and duties of the lender and borrower. As a result, everyone is aware of their roles and responsibilities.

Step 4: Define the consequences

When creating covenants, outlining the implications of breaking the conditions is crucial. Financial fines, debt payback acceleration, or legal action are all possible consequences. All parties are encouraged to abide by the covenant when the sanctions are clearly stated.

Generally speaking

A covenant is essential in financial, real estate, and legal contracts because it makes all parties involved more accountable and transparent. This agreement also outlines the obligations or restrictions to protect everyone's interests. By being fully informed about covenants, you can easily compromise arrangements and avoid potential problems. Knowing how covenants function allows you to protect your rights and make wise decisions.