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What Is a Loan Agreement?
A loan agreement, sometimes used interchangeably with terms like note payable, term loan, IOU, or promissory note, is a binding contract between a borrower and a lender that formalizes the loan process and details the terms and schedule associated with repayment. Depending on the purpose of the loan and the amount of money being borrowed, loan agreements can range from relatively simple letters that provide basic details about how long a borrower has to repay the loan and what interest will be charged, to more elaborate documents, such as mortgage agreements.
Regardless of the type of loan agreement, these documents are governed by federal and state guidelines to ensure that the agreed-upon interest rates are both reasonable and legal.
Why Is a Loan Agreement Important?
Loan agreements are beneficial for borrowers and lenders for many reasons. Namely, this legally binding agreement protects both of their interests if one party fails to honor the agreement. Aside from that, a loan agreement helps a lender because it:
- Legally enforces a borrower's promise to pay back the money owed
- Allows recourse if the borrower defaults on the loan or fails to make a payment
Borrowers benefit from loan agreements because these documents provide them with a clear record of the loan details, like the interest rate, allowing them to:
- Keep the lender's agreement to the payment terms for their records
- Keep track of their payments
When You Can Use a Loan Agreement
Generally speaking, loan agreements are beneficial any time money is borrowed because it formalizes the process and produces results that are usually more positive for all parties involved. Though they are helpful for all lending situations, loan agreements are most commonly used for loans that are paid back over time, like:
- Personal or private loans between friends or family members
- The financing of large purchases, like furniture or vehicles
- Student loans
- Business or commercial loans , like capital loans for startup companies
- Real estate loans, such as mortgages
Loan Agreements vs. Promissory Notes
While promissory notes have a similar function and are legally binding, they are much simpler and more closely resemble IOUs. In most cases, promissory notes are used for modest personal loans, and they usually:
- Are written, signed, and dated by just the borrower
- Specify the amount of money being borrowed
- Detail the terms for repayment
Conversely, loan agreements usually:
- Have repayment terms that are more complex
- Require a signature from both the borrower and the lender
What Should a Loan Agreement Include?
Loan agreements typically include key details about the transaction, such as the:
The loan amount refers to the amount of money that the borrower is receiving.
Interest is used by lenders to compensate for the risk of lending money to the borrower. Usually, interest is expressed as a percentage of the original loan amount, also known as the principal, that is then added to the amount loaned. This extra money charged for the transaction is set at the signing of the contract, but it can be instated or increased if a borrower misses or makes a late payment. Additionally, lenders can charge compound interest where the principal amount is charged with interest as well as any interest that has accumulated in the past. The result is an interest rate that slightly increases over time.
Length of the Contract
The life of a loan agreement is usually dependent on what is known as an amortization schedule , which determines a borrower's monthly payments. The amortization schedule works by dividing the amount of money being loaned by the number of payments that would need to be made for the loan to be paid back in full. After that, interest is added to each monthly payment. Though each monthly payment is the same, a majority of the payments made early in the schedule go toward interest, while most of the payment goes toward the principal later in the schedule.
Unless there are early repayment penalties associated with the loan, it's typically in a borrower's best interest to pay back the loan as quickly as possible because it reduces the amount of interest owed.
Method of Payment
The payment method details how the borrower plans to pay the lender. This can be through:
- One lump sum paid on a certain date at the end of the contract's term
- Regular payments made over a specified amount of time
- Regular payments made specifically toward the interest
- Regular payments made toward the principal and the interest
There are two types of loan repayment schedules:
- Demand: Demand loans are typically used for the short-term borrowing of small amounts without any required collateral. This type of repayment schedule is usually only used between parties that have an established relationship, such as friends and family members. Professional lenders, such as banks, do sometimes use demand loans as well if they have a good relationship with the borrower. The most notable difference between a demand and a fixed loan is that the lender can request repayment whenever they'd like, just so long as enough notice is given. The loan agreement usually details the requirements for notification.
- Fixed: Larger loans, like for a vehicle or car, usually use fixed-term loans. In a fixed loan, repayment follows a schedule that is outlined in the loan agreement and has a maturity date that the loan must be fully repaid by. In many cases, the purchase that the loan funded, like a car or a house, serves as collateral if the borrower defaults on payments. Some fixed loans allow borrowers to pay off the loan early without any penalties, while others charge penalties for early repayment.
Late or Missed Payments
Most loan agreements provide the actions that can and will be taken if the borrower fails to make the promised payments. When a borrower pays off a loan late, the loan is breached or considered in default and they could be held liable for any losses that the lender suffered because of it. Aside from the lender having the right to pursue compensation for liquidated damages and legal costs, they can:
- Increase the loan's interest rate until it is repaid
- Seize collateral or something that has monetary value, like jewelry, equipment, a house, or a vehicle, if the loan can't be repaid
- Place a default or breach on the borrower's credit score
Borrower and Lender Details
Key details about the borrower and lender must be included in the loan agreement, such as their:
- Phone numbers
- Social security numbers
Depending on the loan and its purpose, the borrower and/or lender can either be a corporation or an individual.
Important Legal Terms Found in Loan Agreements
Some of the key terms you should know and understand are:
- Entire agreement clause: This clause means that the final agreement supersedes any previous written or oral agreements that were made during negotiations.
- Severability clause: The severability clause states that the contract's terms function independently, meaning the other conditions are still enforceable even if part of the contract is deemed unenforceable.
- Choice of law: This determines which state or jurisdiction's laws will govern the agreement.
It is in the best interest of both borrowers and lenders to obtain a clear and legally binding agreement regarding the details of the transaction. Regardless of whether the loan is between friends, family, or major corporations, when you take the time to develop a comprehensive loan agreement, you end up avoiding plenty of frustration in the future.
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