Defeasance is the process of terminating a debt obligation. To do this, the borrower must set aside funds to pay back the lender. This is usually done by setting up a trust or escrow account. The funds in this account are then used to pay off the debt obligation when it comes due.  

Defeasance is the act of making something void or inoperative. In real estate, defeasance typically refers to a mortgage or loan agreement clause that allows the borrower to repay the loan early, without penalty, by surrendering the property to the lender. Defeasance can also refer to selling a property to repay a loan.  

What is defeasance? 

Defeasance is extinguishing a debt obligation by using funds from another source. In corporate finance, defeasance is often used when a company wants to refinance its debt without incurring any penalty fees.  

The company sets aside enough money in an escrow account to make all the future interest and principal  payments on the old debt. This allows the company to effectively “buy out” the old debt and replace it with new debt without paying any early repayment fees.

Understanding defeasance 

While defeasance is typically used in real estate, the term can also be applied more broadly to any situation where a contract or agreement is voided or rendered inoperative. For example, a company might enter into a contract with another company only to discover that the other company has gone bankrupt. In this case, the contract would be considered void, and the company would be said to have been defrauded. 

How does defeasance work? 

In the defeasance process, a borrower can prepay a loan and terminate the associated debt obligations. Typically, a borrower must lay aside sufficient funds, either cash or bonds, to pay down their linked debt.  

The amount owing to the creditors and the sum “put aside” to satisfy their debt offset are both included in the fund. Defeasance is often a procedure by which a lender’s claims on collateral are revoked. 

As a replacement for the collateral, the borrower may use a portfolio of minimal-risk assets or another generally risk-free property, such as Treasury bills. By doing so, the borrower’s balance sheet effectively has both sums removed via an accounting method. 

Agreements of the acquisition of real estate frequently contain defeasance clauses. When a mortgage secures a loan, the defeasance provision specifies that the buyer will only get the title to the property once the obligation has been settled fully. The lender keeps the title until the date of repayment. 

Breaking down defeasance 

Breaking down defeasance can be a complex process. Many factors must be considered to ensure the debt is paid off in full and on time. The borrower must first ensure that they have enough funds to cover the entire debt.  

They must then work with the lender to set up the trust or escrow account. Once this is done, they must ensure that the funds are paid into the account regularly. Finally, they must ensure that the debt is paid off in full when it comes due.  

Defeasance can be a complex process, but it is a powerful tool that can be used to terminate a debt obligation. If you consider using a defeasance to pay off your debt, working with a professional who can help you navigate the process is important.

Example of Defeasance 

In a typical defeasance, the bond issuer uses funds from a new loan to pay off the existing bond. This new loan is typically structured so that the bond issuer can make the required payments on the old bond until the maturity date, after which the bond issuer is only responsible for payments on the new loan.  

There are several reasons why a bond issuer might choose to  defease a bond. One reason is to take advantage of lower interest rates. If interest rates fall since a bond is issued, the issuer can save money by refinancing the bond at a lower rate. Another reason is to free up collateral used to secure the bond. This can be important if the collateral is needed for another purpose, such as securing a loan for a new project. 

A defeasance can be a complex transaction, and it is important to work with experienced professionals to ensure the process goes smoothly. 

Frequently Asked Questions

There are a few steps involved in creating a defeasance account. First, you need to identify the bonds included in the account. Next, you need to calculate the present value of the bonds using a discount rate that reflects the current market conditions. Finally, you must deposit the required amount into the account. 

Companies often use defeasance accounts to hedge against interest rate risk. However, there are some disadvantages to using defeasance accounts.  

  • For one, if interest rates rise, the company will have to pay more interest on its debt.  
  • Secondly, if the company defaults on its debt, the account may be frozen, and the company will not be able to access the funds.  
  • Finally, if the company is acquired, the account may be terminated, and the company will lose the benefits of the account. 

The defeasance period is when a defeasance clause is in effect. This clause is typically found in bonds and other debt instruments, allowing the borrower to repay the debt early without penalty. The length of the defeasance period varies, but it is typically shorter than the original term of the debt. For example, if a bond has a term of 10 years and a defeasance period of two years, the borrower can repay the debt after eight years without penalty. 

A defeasance clause is a provision in a contract that allows one party to cancel the contract under certain conditions. The clause typically stipulates that the contract can be terminated if the other party fails to meet certain obligations, such as making timely payments. Defeasance clauses are often used in leases and other types of contracts. 

Defeasance is preparing a debt and terminating the associated interest payments. Yield maintenance is a type of interest rate protection that requires the borrower to pay a premium if they prepay their loan. The premium is calculated using a formula designed to make the lender whole for the interest payments they would have received if the loan had not been prepaid. 

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