What is Defeasance?

Defeasance refers to the substitution of collateral in a loan agreement. It occurs when cash or bonds equivalent to a borrowers debt is substituted for the collateral and used to service the debt. Defeasance often renders a loan void given that the borrower sets aside sufficient cash to offset the outstanding debt. Defeasance is commonly used in a portfolio of U.S securities.

Example of Defeasance

Commercial real estate is a peculiar area where defeasance is commonly used. Often, real estate loans come with pre-payment penalties. Bondholders strive to avoid prepayment penalties in commercial loans by paying off the debt early enough through defeasance. This provision nullifies the prepayment penalties associated with the loan.