How to Understand a Business Loan Agreement
The purpose of a business loan agreement is to document that you’re borrowing money from a lender, whether that be a bank, family member or nontraditional platform. Don’t just put a loan agreement in a drawer and ignore it. That agreement establishes the terms and conditions for the loan, serving as a guide while you pay off your debt.
Understanding a business loan agreement
A business loan agreement documents that a borrower agrees to certain conditions and terms. Traditional banks or other nonbank, alternative lenders draw up the loan agreement form when offering loans. You would encounter a business loan agreement when you take out business financing, including:
After you’ve shopped for a small business loan, undergone the underwriting process and have an offer, it’s time to sign a loan contract. But before you do so, you need to educate yourself on what you’re signing.
Although institutions might use varying terms or different structures to organize information, the components of all loan agreements are generally similar:
A business loan agreement typically includes a promissory note stating the amount you agree to borrow, and the term and interest rate at which you must pay the money back. The promissory note is essentially your promise to pay back the funds you borrow.
If you’re securing a loan with collateral, a loan agreement with collateral would include a security agreement describing the items the lender would be able to seize if you default on payments. This could include business property, equipment or merchandise.
The loan agreement states the interest rate associated with your loan. Several factors influence the rate, such as the collateral you offer and your risk as a borrower.
A higher-than-expected interest rate wouldn’t necessarily be a red flag, but you might want to wait to sign. Shop around — using prequalification when available — to see what terms and interest rates are available to you.
‘If this, then that’ statements
A loan agreement should outline the scenarios you might face when paying off your loan and what could happen if things change within your business. The agreement should also explain what would happen if anything changed on the lender’s side, such as the bank selling your loan to another institution.
The loan agreement should account for all possible situations using statements that illustrate “if this happens, then that happens.” You’ll need to figure out what happens if you can’t make your payments.
Don’t forget the fine print
The most difficult aspects of business loan agreements are usually buried in the fine print. Here are a few examples.
A lender might require you to sign a personal guaranty in your loan agreement. If your business doesn’t have enough assets to secure the loan, the lender might require you and co-owners to sign a personal guaranty giving the lender the right to seize your personal assets if you don’t pay back the loan.
Many business owners designate their companies as corporations or limited liability companies to reduce their personal liabilities. However, signing a personal guaranty puts your assets on the line if your business fails to repay the loan.
A business loan agreement might include a cross-default provision. If you have multiple loans with one lender, defaulting on one loan could trigger default on all your loans with that lender, said Brian J. Thompson, a Chicago-based certified public accountant and business attorney.
Some borrowers like to pay down debt as soon as possible, but a loan agreement might prohibit them from doing that. If you start making extra payments or you pay off your loan early, you could face a prepayment penalty from the lender. Lenders generally want you on a schedule where you pay interest in full.
Late payment penalty
A loan agreement will lay out late payment penalties, which could range from fees to capitalization of your principal balance (the addition of unpaid interest to your loan balance). An acceleration clause in the loan agreement would also enable the lender to move up the due date of your entire loan if you continually make late payments.
Definition of default
Within the loan agreement, the lender will describe what events might trigger a default, such as late payments or falling below a certain asset level within your business. The lender has the ability to decide which of your actions could be considered defaulting on your loan.
Business loan agreement: Terms to know
In addition to the fine print, there are commonly used terms you may come across when reviewing your business loan agreement. Here are some terms you can expect to see:
- Amortization. This is debt paid off over time through equal installments.
- Annual percentage rate (APR). This is the rate reflecting the amount of interest charged, plus any other fees.
- Balloon payment. This is a payment you make at the end of a loan term that is larger than the other installment payments you’ve been making on the loan.
- Cosigner. This person will assume responsibility for the loan if the primary borrower is unable to repay the balance.
- Curtailment. This is a payment you make in addition to your regular payment to reduce the principal balance of the loan.
- Default. This is failure to fulfill the promise made in the loan agreement. An example of default is failing to pay back the loan.
- Deferred payment loan. This is a loan that allows the borrower to make payments at a later date rather than the original due date.
- Factor rate. This is a decimal figure showing the total repayment amount. It’s often associated with merchant cash advances.
- Interest-only payment loan. Rather than amortizing, you pay off this loan with monthly payments covering just interest. Then, you pay off the principal balance at the end of the term in a lump sum or with a new loan.
- Loan-to-value (LTV) ratio. This is the ratio of the loan amount you want to borrow to the value of the asset you’re purchasing with the loan.
- Loan underwriting. This is the process behind the lender’s decision to make a loan based on the borrower’s credit, assets and other factors.
- Principal. This represents the amount of debt remaining on a loan, excluding interest.
- Refinancing. This is when you pay off an existing loan with a new loan.
- Servicing. This refers to loan management, including the collection of payments.
What to avoid in a business loan agreement
The lender will most likely be in the driver’s seat, leaving you with little room to negotiate any aspect of the loan agreement. If you see something in the agreement that you don’t like, your ability to negotiate might depend on the size of your business. Before signing a loan agreement, look out for these red flags.
If your interest rate is adjustable, the percentage might rise after you’ve signed the agreement. A fixed rate would give you a better idea of how much you’ll be paying over time for the loan.
Unmanageable amount of debt
When you enter into a loan agreement, you should go into it with realistic expectations. Abigail Salisbury, a Pittsburgh-based business attorney, said she often asks clients to identify their risk tolerance level to determine how much debt they should take on.
It’s important to make sure your business plan is going to produce the money you need to pay off the loan plus interest, Salisbury said. You should also imagine a scenario in which you can’t make payments and how that would impact your business and daily life.
Small business loan agreement checklist
Once you decide to proceed with a business loan, there are a few steps to take before signing the agreement:
- Determine who would be borrowing the funds — you or your business. Business owners often set up an LLC or corporation but continue to sign documents with their personal name. Make sure you understand if you’re taking out the loan in your name or your business’s name, because this will affect whether you’re personally liable.
- Understand all terms and conditions. Make sure you understand the terms of the loan and the penalties you might face. You should have a clear picture of how the lender defines default so you know what actions to avoid.
- Check the interest rate. The interest rate on your loan would be dependent on your risk as a borrower. If you’re uncomfortable with the rate, you can try to shop around to find a lower one with another lender.
- Set up your repayment plan. The loan agreement might specify how you’ll be expected to make payments to the bank or lender. Salisbury suggests setting up a direct debit to your bank account to ensure on-time payments.
- Ask questions. It’s important to read the loan agreement and note anything you don’t understand. Loan agreements aren’t written in a conversational style, and the legal wording can be confusing to business owners. Don’t let the document intimidate you.
“If you don’t understand it, don’t be embarrassed to ask,” Salisbury said.
Business loan agreement template
If you’d like an example of a business loan agreement before applying for a loan from a lender, or you’d like to draw up a contract before lending to 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.
Before using your own loan agreement in any capacity, be sure to have a business attorney review the document. Or, hire a lawyer to write the contract if you’re unsure how to write a loan agreement template. Mistakes in a loan agreement could result in consequences for both the lender and the borrower. Thoroughly review the document before you sign it.