How to Understand a Business Loan Agreement
A business loan agreement is a legal contract that spells out how you’ll repay borrowed money and what happens if you don’t. To understand one before signing, read closely for four things: the promissory note, the security agreement, the interest rate and any “if this, then that” covenant language.
What is a business loan agreement?
A business loan agreement is the contract a lender and borrower sign to formalize a business loan. It names the parties, the loan amount, the repayment schedule and the consequences of missing a payment, and it applies whether the lender is a bank, an online lender or a family member financing your business informally.
Every business loan agreement covers the same ground: how much you’re borrowing, the interest rate, the repayment timeline and what counts as default. Secured loans add a security agreement describing the collateral, and most small business loans add a personal guarantee that ties your own assets to the business’s repayment.
When you’ll sign a business loan agreement
You’ll sign a loan agreement contract when you borrow money for any type of small business need, including:
After you’ve shopped for a small business loan, undergone the underwriting process and received a financing offer, it’s time to sign the loan contract. Before you do, you need to educate yourself on what you’re signing.
Traditional banks and nonbank, alternative lenders will present you with an agreement in their own preferred format. If you’re borrowing from friends and family, you can find a loan agreement template online and customize it. Institutions use different formats, but the core components are the same across all loan agreements:
Promissory note
A promissory note is a legally binding promise to pay back the money you are borrowing. Some loan agreements incorporate this promise into the language of the loan agreement; others break it out as a separate document.
Security agreement
A security agreement describes the collateral the lender can seize if you default on payments. If you’re securing a loan with assets, the loan agreement will include one, listing the specific items, called collateral, at stake. Collateral can include property, equipment, merchandise or bank accounts.
Interest rate
The loan agreement states the interest rate associated with your loan. Several factors influence the rate, such as the collateral you offer, your credit score as a borrower and the length of the loan, as well as prevailing market rates.
Shop around — using prequalification when available — to see what terms and interest rates are available to you. Ask lenders how you might get a lower rate, for example by offering a personal guarantee, shortening the payoff period or switching to a variable rate loan.
‘If this, then that’ statements
“If this, then that” statements spell out what happens to your loan if specific issues come up during its life. These statements must be very explicit and well explained to protect you from nasty surprises.
A loan agreement should also outline what happens if things change in either your business or the lender’s. For example, what happens to your loan if you sell or shut down your company? How are your terms affected if the lender sells your loan to another institution?
Details to watch for in a business loan agreement
Critical aspects of business loan agreements are often buried in the fine print. The table below breaks down what each clause means and why it matters.
| Clause | What it means | Why it matters |
|---|---|---|
| Personal guarantee | Lets the lender seize your personal assets if the business defaults | Puts your home, car and bank accounts at risk, even if your business is an LLC or corporation |
| Cross-default provision | Defaulting on one loan triggers default on every loan you have with that lender | One missed payment can snowball across your entire relationship with a single lender |
| Prepayment penalty | A fee for paying off your loan early | Can erase the savings you expected from refinancing or paying down debt ahead of schedule |
| Late payment penalty | Fees, rate hikes or interest-on-interest for missed payments | Repeated late payments can trigger an acceleration clause and demand full repayment immediately |
| Default | Missing a payment (financial default) or breaking another loan requirement (technical default) | Defines exactly what can put your loan, and your collateral, at risk. State lending laws vary on what lenders must disclose, so check your state’s regulations or consult an attorney for specifics |
| Blanket lien | Gives the lender a claim on all your business assets, not just named collateral, via a UCC-1 filing | Limits your ability to use those assets for other financing and shows up on your credit report |
Get a business attorney to review the agreement before signing if it includes a blanket lien, a cross-default provision, uncommon covenants or if you’re using a template to borrow from friends or family.
A lawyer can flag how the contract defines default, how far the personal guarantee extends, whether the prepayment penalty is negotiable and whether the terms comply with your state’s lending laws. Most attorneys charge a flat fee for a contract review, not a full engagement, so the cost is usually smaller than the risk of missing something in the fine print.
Business loan agreement: Terms to know
Here are some additional commonly used terms that are important to understanding loan agreements:
- Amortization means equal installment payments that contain both principal and interest. When you finish making payments, the entire loan has been paid off.
- Annual percentage rate (APR) is the true effective interest rate including fees and compounding frequency. When comparing loan proposals, make sure you compare APRs, not just interest rates.
- Balloon payment is the final payoff of outstanding principal on a loan if you haven’t paid it off already through amortization.
- Compounding frequency tells you how often interest is recalculated on the balance you owe. Daily compounding will result in a higher APR than less frequent monthly compounding.
- Cosigner is another person who signs the loan agreement and assumes equal responsibility for the loan along with the primary borrower.
- Curtailment is any extra principal payment you make in excess of your regular required payment.
- Deferred payment loans allow the borrower to postpone making payments for a period of time. However, interest generally continues to accumulate on the unpaid balances.
- Factor rate is an alternative to interest rate. Expressed as a decimal rather than a percentage, the factor rate shows the total amount you’ll need to repay for the loan, regardless of how long it takes. For example, if a loan has a 1.2 factor rate, you’ll need to pay back 120% of what you borrowed.
- Interest-only loans have monthly payments consisting only of interest followed by a lump sum balloon payment of principal at the end of the loan.
- Loan-to-value (LTV) ratio is the ratio of the loan amount to the value of the asset, such as real estate, that you’re financing.
- Loan underwriting is the process behind a lender’s decision to make a loan based on the borrower’s credit, assets and other considerations.
- Principal is the outstanding amount of debt remaining on a loan.
- Refinancing means paying off an existing loan with a new loan.
- Servicing is how lenders refer to loan administration including recordkeeping and collection of payments.
Small business loan agreement checklist
Once you decide to get a business loan, confirm these items before signing the agreement:
- Determine who’s borrowing the funds. Personal loans make you personally liable for defaults. If the loan is in the name of your business LLC or corporation, you’ll still sign documents but use your legal title as chief executive signing on behalf of the business.
- Understand all terms and conditions, including how the lender defines default and what penalties apply, so you know what actions to avoid.
- Check the interest rate by calculating the APR. Interest rates vary a lot between lenders, so it’s worth shopping around.
- Set up your repayment method. The lender may require direct debit access to your bank account or they might allow you to pay by check.
- Get every unclear clause explained before you sign. Loan agreements are written in legal wording that can be confusing, so ask the lender or an advisor rather than guessing what a term means.
If you’d like to see an example of a business or LLC loan agreement, or want to draw up a contract to use in borrowing from friends or family, search online for a template. LawDepot provides free business loan agreement templates that you can customize based on your state and transaction details.
Treat any template as a starting point rather than a finished contract, and have a business attorney review it before you sign.
What to avoid in a business loan agreement
A commercial lender won’t likely allow much room to negotiate terms of their business or LLC loan contract. Before signing the loan agreement, look out for these red flags.
Variable rates
A variable rate can rise during the life of the loan, driving up your payments unpredictably. A fixed interest rate may start out higher, but gives you assurance that it won’t change over time.
Unmanageable amount of debt
An unmanageable amount of debt puts your business, and your personal finances if you’ve signed a personal guarantee, at risk the moment cash flow dips. Before you enter into a loan agreement, consult your business plan to see if it’s realistic that you’ll have the money you need to pay off the loan plus interest.
Run the numbers with our business loan calculator to see what your actual monthly payment would look like before you sign.
Unexpected terms
Unexpected terms are provisions you don’t recall discussing with the lender, and they’re worth pausing for. When carefully reading the business loan agreement you may notice one. Don’t ignore it. Get clarification on anything you didn’t expect to find, and if it’s a clause like a blanket lien or cross-default provision, that’s a sign to get an attorney to review the full agreement before you sign. Once signed, the loan contract is legally binding whether you understood it or not.
Compare business loan offers