If you’re a new business owner considering applying for a business loan, you need to make sure you’re carefully reviewing your business loan agreement. This document outlines the terms, conditions, and other logistical details about the loan, which you’ll need to record for legal and repayment purposes. Whether you’re borrowing money from a traditional bank or a third-party lender, the loan agreement will play a key role in helping you determine if the borrowing and repayment procedures align with your current financial needs.
Ideally, it’s best to have a lawyer present to look out for problematic clauses, but this isn’t always possible, especially for sole proprietors and new small business launches. However, you can still decipher a business loan agreement for yourself by paying attention to the following components, terms, and items.
- A business loan agreement documents the terms and conditions of the loan and also includes important information such as the loan amount, repayment details, APR, and fees.
- When reviewing a business loan agreement, watch out for clauses on prepayment fees and penalties, and personal guarantees.
- Consult a lawyer if you’re unable to clearly understand any portion of the document.
What Is a Business Loan Agreement?
A business loan agreement is a document outlining the terms and conditions of the current and future (repayment) logistics of the loan. It is a legally binding agreement signed by both parties to establish clear responsibilities and help both the borrower and the lender feel secure within the arrangement.
A business loan agreement is typically required when you’re taking a loan to start a new business, buy an existing business, upgrade machinery, hire new staff, or fund other operations that will help keep your business running.
Components of a Business Loan Agreement
Business loan agreements may come in varying formats with different sections, however, most of them share some common legally required features. Here are the most important components typically included in business loan agreements.
Business Loan Amount
The first component of a business loan agreement is the amount of money borrowed, also known as a promissory note. This will usually be stated both in words and in a numerical format. For instance, a business loan agreement may say something along the lines of “Borrower has requested that Lender extend to Borrower a loan in the amount of Fifty Thousand and No/100 Dollars ($50,000).”
The loan needs to be repaid at some point in the future, so this section highlights the exact process and timeline for repayment. This will include details about your payment schedule, any grace period, and late-payment fees as well as which methods of payment are accepted (credit cards, e-transfers, bank deposits, etc.), the amount to be paid each month or quarter, and so on.
When you borrow money, you don’t just repay the borrowed amount. You’re typically charged a rate of interest. This annual percentage rate, or APR, tells you how much you'll pay in interest every year while you're repaying the loan along with whether the interest rate is fixed or variable (and when/if that will change).
What happens if you fail to repay the due money on time? You’re typically charged late fees or a higher rate of interest, depending on the terms of your agreement. Also called penalty fees, these can be levied if you breach any of the payment terms outlined in your agreement.
Items To Watch Out For
Along with the traditional components of a business loan agreement, you also need to watch out for specific sections in the document that may be problematic.
While some lenders will charge an origination fee to cover the administrative costs of processing your loan, you should not typically have to pay any exorbitant fees upfront in order to receive a business loan.
If you don’t have enough business assets to use as a security guarantee for the loan, some lenders may ask you to use your personal assets (house, car, etc.) as collateral. This gives the lender the right to seize your personal property if you’re unable to repay the loan on time.
While it’s ideal to repay your loan early, some lenders may fine you for doing so. If you pay before the due date, the lender earns less interest on the borrowed sum and hence they may insist payments be made only according to the scheduled timeline. Be sure to review the fine print to see if this will affect you, especially if you think you may want to repay your loan early should you have an influx of cash.
When applying for a business loan, it’s also important to understand your lender’s definition of loan default, sometimes referred to on the loan agreement as “Events of Default.” Some lenders will offer a grace period for one or two payments, while others will pursue collection and/or legal action after a single missed payment or if there has been a misrepresentation in any financial statement, report, or certificate provided to them.
Important Terms To Know
Here are some important terms to know when reading a business loan agreement.
Amortization: This outlines how your loan repayments are set up. An amortized loan means you’ll repay your loan with equal, scheduled payments typically on a monthly basis.
Balloon payment: Some loans require a hefty lump-sum payment at the end of your loan term. This is usually the case if you’ve been making interest-only payments; this balloon payment amount is intended to repay the principal debt.
Blanket lien: This gives a lender the right to your business’s assets and property should you default on your loan.
Co-signer: A co-signer signs the business loan agreement with you and assumes responsibility for repaying the loan if you fail to do so.
Default: Default occurs when you fail to fulfill your contractual obligations (for example, failing to make payments on time or breaching one of the lender’s “Events of Default”). A default could result in the lender seizing your assets or imposing penalties.
Evidence of insurance: This documentation shows lenders that you will maintain and keep in force insurance to protect you from liability from industry-specific issues, fire, property damage, workers’ compensation, etc.
Indemnification: This is designed to protect the lender against any and all claims, liabilities, losses, damages, and expenses.
Before You Sign Your Loan Agreement
Before signing a business loan agreement, be sure to read through the fine print to ensure there are no problematic causes that will land you in trouble in the future. It’s important you understand exactly what each term means and how it will affect your repayment.
In addition, consider the trustworthiness of the lender. Avoid lenders with high rates, suspicious policies, and shady practices. You can typically inquire about a business loan at your local bank. Finally, consult a lawyer if you’re unable to understand what a clause means and how it will impact your business.
Frequently Asked Questions (FAQs)
What is not covered in a business loan agreement?
While most loan agreements can be quite comprehensive, not all documents include every section detailing all the processes. For example, some agreements may not include information about the method of repayment and focus only on the time and amount of repayment.
Why is a loan agreement important?
Loan agreements are important to ensure the borrowing and repayment process is recorded for legal reference. Having a signed document is also helpful to ensure both parties are on the same page regarding the borrowing and repayment expectations to avoid problems in the future. A loan agreement can serve as a handy reference for tracking the timeline of payment, interest rate, and penalties for default.
How do I write a legally binding loan agreement?
It’s best to consult a lawyer or a relevant expert to write a legally binding loan agreement. If that’s not accessible for your business, make sure your document includes all the key components and fair clauses to ensure you’re not voiding any legal policies.
Want to read more content like this? Sign up for The Balance’s newsletter for daily insights, analysis, and financial tips, all delivered straight to your inbox every morning!