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Tata Capital > Blog > Loan for Business > What is Defeasance and How Does it Work?

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What is Defeasance and How Does it Work?

What is Defeasance and How Does it Work?

The business landscape can often be overwhelming to navigate. Hundreds of financial clauses and strategies are constantly at play, where you require proper knowledge of every financial aspect in order to run a successful business.

If you aspire to be a successful businessman, you must be aware of the financial strategies that leaders usually utilise to minimise their expenses and maximise their profits. One such strategy is defeasance– a complicated yet rewarding method of cutting down on loan-related expenses through the replacement of collateral value.

In this article, we will be learning more about this enigmatic financial strategy, including its pros and cons, and better understand its role in business financial management.

Understanding Defeasance Meaning

To put it simply, defeasance is a specific provision in business law that allows the borrower to cancel a bond or loan on a financial statement. However, this is only done when the borrower sets aside enough cash or bonds to pay off the debt.

In such cases, the value of the cash or bond is supposedly equal to the debt remaining to be paid. With both values being the same, the two components completely offset each other, making it easier for the debt to be completely removed from the balance sheet.

Usually, the provisions entailed under the defeasance account also include some other requirements that the borrower must fulfill before the interest proceeds are released by the lender.

How Does Defeasance Account Work?

To better understand this financial strategy, let us take a loan defeasance example:

Suppose there is a real estate company called XYZ Corps. This company has taken a commercial mortgage loan to finance its purchase of a new office building. The loan was structured with a 10-year tenure and a defeasance clause.

Five years down the line, XYZ Corps identifies an opportunity to sell the office building at a profitable price due to market appreciation. However, the company is unable to sell the property due to loan terms. Owing to the pre-payment penalty, the final cost to the company is not coming up to be economically favourable.

To counter this, XYZ Corps decides to invoke the defeasance clause. It brings together a team of legal and financial experts to handle defeasance and protect the process from the company's financial risks.

Under the guidance of the expert team, XYZ Corps picks up government-backed securities that can cover the remaining debt payments. These securities are then pledged to the lender as new collateral, and the lender is asked to release their property from the debt.

After the legal process is taken care of, the lender officially accepts securities as collateral in exchange for the property. Since the property is now no longer bound by the loan terms, XYZ Corps was able to sell it for a profit and was not liable to pay any pre-payment penalty.

Defeasance Account Creation

Before you jump the gun and make up your mind to create a defeasance account, you should know that creating a defeasance account is a complicated and time-consuming process. Usually, business leaders steer clear of solo preparation of defeasance accounts.

To ensure that the defeasance clause is invoked without any hitch, leaders take help from a team of legal and financial advisors. This team of experts ensures that the portfolio required for cost substitution is properly maintained. Ultimately, the team must ensure that the portfolio generates enough funds required for the proper utilisation of the defeasance clause.

Advantages of Defeasance

Opening a defeasance account provides business owners with loads of benefits:

Reduces accounting complexity

One of the biggest benefits of defeasance is its ability to simplify the accounting process. Instead of recording every single instance related to the loan, defeasance allows you to completely remove the debt from your balance sheet. This can help in simplifying the accounting process and reduces unnecessary complexities.

Decreased risk of pre-payment penalty

In most cases, when a business seeks to pre-pay their business loans, the lender levies some pre-payment penalty on the borrower. The reason behind that is simple– the lender wants to recover some amount that it lost from future interest payments. However, by utilising the defeasance clause, borrowers can protect themselves from such extra charges.

Savings from high interest payouts

Business loans usually involve high principal amount. As a result, the interest payout levied on such loans is also significant. So, if there are chances of interest rates increasing in the future, business leaders can benefit immensely from defeasance. With the help of this clause, borrowers can skip the costly interest payments and save up on high interest payouts.

Disadvantages of Defeasance

Even with its benefits, there are some major disadvantages to this financial strategy:

High cost

The process of opening a loan defeasance account is not something that business leaders take up on their own. Infamous for its complexity, business owners usually require the assistance of legal and financial advisors to pull this off. Due to the requirement of such experts, the process includes various expenses like transactional fees, legal costs, and so on.

High capital requirements

Invoking the defeasance clause demands a high capital requirement. The borrower must have sufficient funds to replace the value of the collateral in question and remove the debt obligation from the balance sheet.

Parting Thoughts

Defeasance is a sophisticated financial strategy that balances the interests of borrowers as well as lenders. By providing borrowers with a pathway to release assets from existing obligations, this strategy reduces accounting complexity and protects the business from pre-payment penalties. However, defeasance is riddled with complexities, making it difficult to utilise without proper financial guidance.

That said, you don’t need to take the complicated route of opening a defeasance account if your business loan has favourable terms. With Tata Capital, you can avail of business loans that are renowned for their competitive business loan interest rates and swift approvals.

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