The Ultimate Guide to Understanding a Business Loan Agreement
After you’ve shopped for a small business loan, survived the underwriting process and finally have a loan offer in your hands, it’s time to sign an agreement. But before you put pen to paper, you need to educate yourself on exactly what you’re signing.
The purpose of a business loan agreement is to document that you are borrowing money from a lender, whether that lender is a bank, a family member or a nontraditional lending platform, Abigail Salisbury, a Pittsburgh-based business attorney, said. “Don’t just throw that thing in a drawer and never look at it again,” Salisbury said. The loan agreement establishes the terms and conditions you must adhere to for the life of your loan and it serves as a guide while you pay off your debt.
Keep reading to get a handle on the basics of business loan agreements so you can feel confident about the terms of your loan agreement.
Understanding the fundamentals of a business loan agreement
A business loan agreement contains documents a borrower signs agreeing to certain conditions and terms. According to Brian J. Thompson, a Chicago-based CPA and business attorney, traditional banks or other nonbank, alternative lenders draw up the agreement when offering loans. Although institutions might use varying terms or different structures to organize information, the components of all loan agreements are similar, and as follows:
A business loan agreement typically includes a promissory note stating the amount you agree to borrow and the term and rate at which you must pay the money back, Thompson said. The promissory note is essentially your promise to pay back the funds you borrow.
If you’re securing a loan with collateral, the loan agreement would include a security agreement describing the items the lender would be able to seize if you default on payments, Thompson said.
The loan agreement states the interest rate associated with your loan. Several factors influence this figure, such as the collateral you offer and your risk as a borrower, Thompson explained. A higher-than-expected interest rate wouldn’t necessarily be a red flag, but you might want to wait to sign the agreement until after you’ve explored other options.
“The riskier you are as a borrower, the higher the interest you’re going to pay,” Thompson said. “Borrowers should shop around and get a sense of where they are on the credit risk spectrum and what sorts of terms are available for them.”
“If then, 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, Salisbury said. 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,” Salisbury said.
“You have to figure out what happens if you can’t make your payments,” Salisbury said.
Don’t forget the fine print
Although the CARD Act has made strides in requiring more clear and transparent agreements, the most difficult terms to locate are usually buried in the fine print. Below are a few examples:
A lender might require you to sign a personal guarantee within your loan agreement, and it’s crucial that business owners understand what it entails. If your business doesn’t have enough assets to secure the loan, the lender might require you and co-owners to sign a personal guarantee giving the lender the right to seize your personal assets if you don’t pay back the loan.
Thompson warned that many business owners designate their companies as corporations or limited liability companies to reduce their personal liabilities; however, signing a personal guarantee puts your assets on the line if your business fails to repay the loan.
A business loan agreement might include a cross-default provision, which many business owners don’t understand. If you have multiple loans with one lender, defaulting on one loan triggers default on all of your loans with that lender, he said.
“It’s not something you encounter as a consumer,” Thompson said. “That happens in a commercial context.”
Some people like to pay down debt as soon as they can, but Salisbury warned a loan agreement might prohibit you from doing that. If you start making extra payments or you pay off your loan early, you could face a penalty from the lender.
“They want you on a schedule because they want you to pay that interest,” Salisbury said.
Learn more about prepayment penalties on business loans here.
Late payment penalties.
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 full 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, Thompson explained.
Understanding the terminology of a business loan agreement
There are a few commonly used terms you’ll likely come across when you’re reviewing your loan agreement. Here’s some jargon you can expect to see in your loan agreement:
- Amortization. This is debt paid off through equal periodic payments made at the end of a fixed period.
- Annual percentage rate (APR). This is the rate reflecting the amount of interest earned or charged.
- Balloon payment. This is a payment you must make at the end of the loan term that is larger than the other installment payments you’ve made throughout the life of the loan.
- Co-signer. A person who will assume responsibility of the loan if the primary cardholder is unable to repay the balance/debt.
- 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, such as 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 at signing.
- Factor rate: This is a decimal figure showing the total repayment amount, which is often associated with merchant cash advances.
- Interest-only payment loan. Rather than amortizing, you pay this loan is off with monthly payments of just interest, then you pay off the principal balance in one lump sum at the end of the loan term.
- Loan-to-value ratio (LTV). This is the ratio of the principal balance of a loan to the value of the asset that the loan covers.
- 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
“You might want to avoid adjustable rate loans,” Thompson said. If the 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.
“You can end up with a payment that’s more than you expected,” Thompson said.
When you enter into a loan agreement, Salisbury explained, you should go into it with realistic expectations. 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.
“Before you get involved in the loan process, have an understanding if you’re realistically going to be able to pay it back,” Salisbury said.
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’ name, because this will affect whether you are personally liable for the loan, Salisbury said.
- Understand all terms and conditions. Make sure you understand the terms of the loan and the penalties you might face, Salisbury said. 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, Thompson said. If you’re uncomfortable with the numbers, you can shop around to find a lower rate with another lender.
- Set up your repayment plan. The loan agreement might specify how you will 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 all the way through and note of anything you don’t understand, Salisbury said. Loan agreements are not 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.
The bottom line
A business loan agreement explains what a lender expects of you once you commit to taking out a loan. Thoroughly review the document before you sign it so you understand what you’re getting yourself into. “The biggest thing is understanding those terms and what the consequences are,” Salisbury said.
The lender will most likely be in the driver’s seat, leaving you with little room to negotiate any aspect of the agreement, Thompson said. If you see something in the agreement that you don’t like, your ability to negotiate might depend on the size of your business.
“If you’re a small business, you may be presented with a ‘take it or leave it’ sort of offer,” Thompson said. If you’re attempting to borrow a large amount of money, however, the lender might make adjustments to the terms based on your requests. The best way to know what portions are up for discussion would be to hire an attorney to look over the documents.
“If you can possibly retain an attorney to advise you, a little bit of money spent up front can save you from a lot of headaches down the road,” Thompson said.