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Business loan agreements govern relationships between borrowers and lenders by detailing key information like repayment terms and collateral. The loan agreement protects all parties on the contract by ensuring everyone understands their rights and responsibilities. For that reason, it’s important to understand the most common sections and terms of a loan agreement.
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What Is a Business Loan Agreement?
A business loan agreement is a legally binding document that outlines the details of a loan between a lender and borrower. Loan agreements typically include information like the loan amount, repayment term and due dates, interest rates and other costs.
Not only do the best small business loans boast competitive rates and terms, but they also come with transparent loan agreements that business owners can understand.
How a Business Loan Agreement Works
Business loan agreements generally are provided by the lender—especially when working with banks, credit unions and other financial institutions. However, business owners who take out a private loan from an individual may need to provide their own agreement. In this case, there are a number of forms and agreement templates available online.
Keep in mind, however, that it’s best to consult with a business attorney when drafting a loan agreement. Likewise, it’s important to understand the most common sections of a loan agreement before it’s time to get a business loan.
Sections of a Business Loan Agreement
Most business loan agreements include the same general sections. The majority of variation occurs within these sections, where lenders can set their own terms and establish loan details as well as the mechanics of repayment, nonpayment and default. These are some of the most common parts of a business loan agreement:
The effective date of a business loan agreement is the date on which it becomes binding on all parties. With a loan agreement, this is usually the day the loan funds are disbursed.
Parties, Relationship and Loan Amount
Every loan agreement should include the names of the lender and borrowers at the beginning of the document, including each party’s address or other identifying information, as well as the relationship between the parties.
If there’s a co-signer on the loan, also include identifying information and describe their relationship under the contract. Finally, state the loan amount in this first part of the agreement.
Promissory Note or Mortgage
A promissory note is a portion of a loan agreement stating that the borrower agrees to repay a set loan amount at a set interest rate. As the name suggests, a promissory note is simply a promise to pay.
For a secured loan, the loan agreement should include a section that describes the collateral—generally referred to as the security agreement. In the case of a mortgage, the underlying collateral is the land and/or building being purchased. However, collateral may also be the financed vehicles or equipment, or other company assets.
Terms and Conditions
This section of a business loan agreement generally includes the details of an installment loan, including the installment agreement, as well as basic information like the loan amount, term and interest rate. This section also may state whether prepayment is permitted under the terms of the agreement.
Penalties for Nonpayment
The nonpayment section of a loan agreement describes what happens if the borrower misses a payment. Typically, this section indicates whether there is a grace period during which the borrower can make a late payment without being penalized.
Defaults and Acceleration Clause
This section describes what happens if the borrower defaults on the loan, including fines and other penalties. Likewise, the contract may include an acceleration clause that states that the entire loan balance becomes immediately payable if the borrower fails to meet all requirements set forth in the agreement.
Jurisdiction and Governing Law
Because law varies from state to state, every business loan agreement should include a section that specifies which state law is controlling. This is especially important in the case of a contract dispute, but it also dictates how the overall contract is drafted. For that reason, it is best to hire a local attorney who can ensure the loan agreement complies with applicable state law.
Representations of the Borrower
As part of a loan agreement, the borrower is expected to make a number of representations. This may include asserting that the borrower can legally do business in the state, that all financial representations made are true and correct, and that the business is in compliance with tax law.
A covenant is a promise made between the parties to a loan agreement. In general, the lender covenants to disburse funds in a certain amount and at a specified rate of interest, while the borrower promises to repay the loan according to the terms of the agreement. However, there are several more specific covenants found in business loan contracts, including a promise to:
- Provide proof of insurance for pledged collateral
- Acquire key person insurance on the life of the business owner
- Show evidence of payment for taxes and fees, including property taxes and vehicles licenses
- Pay lender expenses in the case of loan default
- Periodically produce financial statements during the loan term
- Refrain from taking on additional business debt during the loan term
Business Loan Agreement Terms
With all of the legal jargon present in business loan agreements, it can feel like documents are written in another language. However, understanding a few common terms can make it easier to interpret these contracts. Familiarize yourself with these terms before signing a loan agreement:
- Amortization. Loan amortization refers to the way a fixed-rate loan is scheduled into equal payments over the repayment term. Typically, each payment includes interest and payment toward the loan principal.
- Annual percentage rate (APR). The APR on a loan represents the annualized cost of borrowing, including the rate of interest and additional charges and fees.
- Automated Clearing House (ACH). In the context of business lending, automated clearing house payments are a type of loan payment that’s made through automatic withdrawals from the borrower’s bank account.
- Balloon payment. Typically, term loan payments include a portion of interest accrued and a portion of the loan principal. In this case, the principal is entirely repaid over the course of the loan term. However, some loans are structured so that all or a portion of the loan principal remains at the end of the term and must be repaid as a single balloon payment.
- Blanket lien. A blanket lien covers all of a business’ assets, not just a specific piece of collateral. In case of borrower default, this type of lien allows the lender to attach to any of the borrower’s assets to recoup the outstanding loan balance.
- Co-signer. A co-signer is someone who can improve a prospective borrower’s chances of loan approval by agreeing to pay back the loan if the primary borrower defaults. Where applicable, the co-signer to a business loan is identified in the loan contract along with their responsibilities under the agreement.
- Curtailment. Curtailment refers to when a borrower pays more on their loan than is currently due in a month—or more than the monthly payment established in the loan agreement. A partial curtailment occurs when the borrower makes an extra payment but does not pay off the entire loan; a full curtailment involves paying off the loan in full.
- Default. Defaulting on a business loan occurs when the borrower does not make payments in accordance with the loan agreement. If a borrower defaults, the lender can take legal steps to recoup the outstanding loan balance from the borrower or co-signer.
- Deferred payment loan. Under a deferred payment loan, the lender and borrower agree that payments start on a specified future date—not immediately, as is the case with traditional term loans.
- Factor rate. Certain types of business financing, like invoice factoring and merchant cash advances, have a factor rate instead of a traditional interest rate. In contrast to traditional interest rates, factor rates are expressed as a decimal that represents the factor of the total loan amount that will be repaid in total. For example, if the factor rate on a $10,000 loan is 1.2, the borrower will repay a total of $12,000.
- Interest-only payment loan. An interest-only loan payment is one that only covers a predetermined portion of interest accrued on the loan—not the loan principal itself. When the loan term is up, the loan principal is repaid in full or refinanced.
- Loan-to-value (LTV) ratio. The loan-to-value ratio of business financing represents the portion of an asset’s value covered by a loan. This is especially relevant to businesses that want to finance the purchase of equipment or real estate.
- Loan underwriting. Underwriting is the process a financial institution uses to evaluate how much risk a borrower poses to the lender.
- Prepayment penalty. Some lenders charge borrowers a prepayment penalty for paying off a loan before the end of the full loan term. Because lenders expect interest to accrue over the entire loan term, paying off a loan early can result in a loss of those funds. Prepayment penalties are meant to make up for that loss.
- Principal. The loan principal is the amount a business borrows—the loan amount—exclusive of accrued interest. A portion of each loan payment covers interest, with the remainder covering some of the principal.
- Refinancing. The process of refinancing involves taking out a loan to pay off the balance of another loan. Refinancing is often used to access lower interest rates or to lower the monthly payment on an existing loan.
- Servicing. Loan servicing is a broad term that refers to the management of a loan, including how loan funds are disbursed, how payments are collected and what happens in the case of borrower delinquency.
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