The Basics of a Loan Agreement

Why is a loan agreement needed?

A loan agreement is a tremendously vital part of borrowing money. Without a formal agreement, neither party is protected should any of the loan terms be violated. The loan agreement details repayment terms, important dates, interest rates and fees. This way, everyone knows what’s expected of them.

Without a loan agreement, your lender could potentially raise your rate or charge higher fees, and the borrower would be required to pay. For the lender, the agreement also protects them if a borrower is late with a payment or defaults on the loan.

The loan agreement protects you from the IRS, because it is proof that the money you have acquired is a loan and not a gift that could create a tax event.

Loan agreements actually help to build trust. Borrowing money and lending money are based on trust, and a loan agreement plainly describes what both sides, borrower and lender, are entrusted with successfully accomplishing.

What exactly is a loan agreement?

A loan agreement is a formal and legal document, signed by both lender and borrower, clearly delineating the terms of the loan. These contracts are binding and can be simple or complex. The loan agreement plainly describes the repayment schedule, the costs to the borrower, and any other rules or requirements. Loan agreements must follow state and federal guidelines to protect both the borrower and the lender.

What are the basics of a loan agreement?

Loan agreements can vary from one lender to the next, but here’s what to expect:

Borrower information. This is the name and any contact information of the person or business applying for the loan. This step often requires photo identification presented to a notary at signing.

Transaction information. This is where loan details are established, including the amount borrowed, the interest rate, the type of interest, the repayment terms and important dates.

Reporting requirements. The reporting requirements section outlines the financial reporting required from the borrower, such as when and how to submit the loan documentation.

Collateral requirements. Most investment or business-related loans require collateral and/or a personal guarantee. If that’s the case with your loan, the details will be in this section of the agreement.

Lien covenants. If a property lien is part of your loan contract, then you cannot incur any further liens during the lifetime of the loan.

Prepayment penalties. These penalties are fees that the lender charges the borrower for paying off the loan before the end of the term originally set in the loan agreement. These fees may seem unusual after the borrower has honored their pledge to repay the loan; however, prepayment penalties are typically included to protect lenders.

Lenders are sometimes willing to work with investors and business owners on a few of the loan contract terms, if needed. Sometimes special circumstances require creative solutions. Most lenders do not want a loan default, and their goal is to write an agreement that both sides can successfully accomplish.

Both lender and borrower should carefully review the loan agreement to protect their business and investment interests. Everyone should enter into a loan agreement as informed as possible on the details. Trusting lender and borrower relationships can span decades, so it is worth starting things off in the right way.