How to Understand a Business Loan Agreement
A business loan agreement documents your obligations when you’re borrowing money from a lender, whether that be a bank, family member or nontraditional lending platform.
Make sure you understand the loan agreement before you sign it: It’s a legal contract that establishes when and how you must pay off your debt and the penalties you’ll pay if you don’t.
Understanding a business loan agreement
You’ll need to 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. Although institutions might use varying terms or different structures to organize information, the components of all loan agreements are generally similar:
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
If you’re securing a loan with assets, the loan agreement will include a security agreement describing the items, called collateral, that the lender will be able to seize if you default on payments. 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 floating rate loan.
‘If this, then that’ statements
The loan agreement should clearly spell out “if this happens, then that happens” for possible issues that may come up during the life of the loan. 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?
Don’t forget the fine print
Critical aspects of business loan agreements are often buried in the fine print. Here are a few examples.
Personal guarantee
Lenders frequently ask you and your co-owners to sign a personal guarantee for a loan to your sole proprietorship or LLC. A personal guarantee gives the lender the right to seize your personal assets, possibly including your home, cars and bank accounts, if the business doesn’t pay back the loan on the agreed upon terms.
Even if your business is set up as a corporation or limited liability company to reduce your personal liability for its operating activities, signing a personal loan guarantee puts your assets on the line for loan defaults.
Cross-default provision
A cross-default provision applies if you have multiple loans with the same lender. Defaulting on one loan could trigger default penalties on all of those loans.
Prepayment penalty
There may be times you’d like to pay off all or part of your loan early because you have extra cash on hand or have found a new loan with better terms. Depending on the provisions of your loan contract, you could face a prepayment penalty or additional fees for paying off the loan early.
Late payment penalty
The loan agreement will specify late payment penalties like fees, interest rate adjustments and capitalization of interest (interest charged on your unpaid interest). If there’s an acceleration clause in the loan agreement, repeated late payments could even allow the lender to terminate the loan and require immediate repayment in full.
Definition of default
Default is failure to fulfill promises made in the loan agreement. Financial defaults occur when loan payments are late or skipped. Technical defaults pertain to lapses on other loan requirements like providing copies of your annual tax returns, maintaining your facilities or keeping a certain amount of cash in the bank.
Loan agreements describe exactly what events will trigger a default and what the consequences will be, which are called remedies. The list detailing the loan requirements and remedies is called the loan covenants.
NOTE: Your state may have unique lending laws regulating what lenders must disclose in loan contracts, maximum interest rates they can charge and other aspects of small business loan agreements. Search the internet for state lending regulations or consult with an attorney to get details.
Blanket lien
If you’ve pledged assets as collateral for your business loan, the lender will likely make a UCC-1 filing publicly declaring its right to take those assets if you default. This is also called a UCC lien. It may list specific assets or, if it’s a blanket lien, may lay claim to all your company’s assets, including inventory, accounts receivable, vehicles and equipment.This can even include future assets that you don’t own yet.
Assets listed in a UCC lien can’t be used as collateral for other loans or sold without the lender’s permission. Since UCC liens show up on your credit report they may hamper your ability to get additional funding because potential future lenders know that others have first dibs on your assets, which increases their risk of lending to you.
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, 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, there are a few steps to take before signing the agreement:
- Determine who will be borrowing the funds — you or your business. 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. You should have a clear picture of how the lender defines default and the penalties involved so you know what actions to avoid.
- Check the interest rate by calculating the APR. Interest rate varies 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.
- Ask questions. It’s important to get explanations for anything you don’t understand. Loan agreements are written in legal wording that can be confusing. Don’t let the document intimidate you — get help from a knowledgeable advisor.
Business loan agreement template
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.
Before using your own loan agreement, be sure to have a business attorney review the document. Or you might opt to hire a lawyer to write the contract. Mistakes in a loan agreement could result in unwanted consequences for both the lender and the borrower.
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
If your interest rate is adjustable, the percentage may rise during the life of the loan. A fixed interest rate may start out higher, but gives you assurance that it won’t change over time.
Unmanageable amount of debt
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. You should also imagine a scenario in which you can’t make payments and how that would impact your business and daily life.
Unexpected terms
When carefully reading the business loan agreement you may notice a term or provision that you don’t recall discussing with the lender. Don’t ignore it: Get clarification on anything you didn’t expect to find. Once signed, the loan contract is legally binding whether you understood it or not.