A loan novation agreement is a contract between parties in which one of the parties is replaced with another, or one of the obligations under the contract is replaced with another requirement. This is the exact definition of novation. It is similar to the concept of an assignment; however, there are some key differences between the two.

Novation vs. Assignment

There are 3 key differences between a novation and assignment, as follows:

1.Transferring of responsibility

2.Consent requirement

3.Termination of the original contract

Novation involves transfers of the obligations and responsibilities under the contract, whereas an assignment doesn’t transfer such responsibilities. Furthermore, the assignment of a contract doesn’t generally require consent of the benefiting party; novation does require such consent. Lastly, assignment doesn’t terminate the original contract where novation does in fact terminate the original contract, and the loan novation agreement steps in as the refreshed version.

Novation Agreement: An Overview

The novation is a way to transfer debt to a wholly unique party, who will then step in and take the place of the original party in the contract. Such change requires consent of both parties, including the party that is benefiting from the change. An example of this would be if a person obtains a loan from a lending bank for coverage of student fees. Thereafter, while the student (debtor) is paying back the loan, the lender will sell the remainder of the loan to another lending institution. This is common in student loans as well as home mortgages. Thereafter, the old lender will have no obligation under the original contract; it will be as if the original contract ceased to exist and is replaced with the new loan agreement.

When engaging in novation, the parties will cancel the original contract and create a brand new contract. However, the same terms and provisions must be kept in the agreement, since it would be too burdensome for the debtor to modify the repayment terms. With that said, the lender might continue to keep some obligations that the debtor hasn’t taken advantage of. This could occur if the debtor hasn’t used loan funding that was previously available via a revolving credit facility.

Novation Agreement Examples

For example, if John owes Sue $100, but Sue owes George $100, the responsibility under both parties could be subject to a novation in which John will directly pay George $100 rather than have Sue involved. Thus, John, Sue, and George can all come to an agreement that instead of Sue being involved in the payments, John will pay George the $100 without involving Sue in the transaction. As such, John and George might come up with their own agreement, i.e., John might offer George a $100 gift card that George might accept as a form of payment.

Novation could also occur in property arrangements whereby a tenant signs an annual lease with a landlord. During such lease, the tenant might wish to sublet the apartment to a third party, so long as the landlord agrees. If the landlord agrees to this, then the person subletting and landlord could enter a novation removing the original tenant from the contract, and starting their own contract. However, this is only if all parties agree, including the original tenant.

Novation agreements can also be found in construction contracts. An example of this would be if a contractor transfers duties to another contractor, i.e., subcontracting, with the client’s approval. If the subcontractor takes over full responsibilities for the contractor, then the client and subcontractor might enter into a loan novation agreement discharging the original contractor from his duties.

In the derivative market industry, novation will have a different meaning. It refers to an agreement with a clearing house. Instead of transacting directly with buyers, the seller transfers his securities to the clearing house, which in turn will sell them to the buyer. Therefore, while the transaction is bilateral, the clearing house will still act as the middle man. This reduces the credit risk for participants of the transaction who might be unable to identify the credit rating or worthiness of the other party involved. The only risk on the part of both parties is that the clearing house will be insolvent.

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