- Loan agreements are an important part of borrowing money; they protect both the borrower and the lender.
- A loan agreement spells out the details of the transaction, including the loan amount, the interest rate and the terms.
- Lenders expect business borrowers to meet certain reporting and financial requirements; if you don’t, they can recall your loan.
- This article is for entrepreneurs and small business owners who are thinking about taking out a business loan.
In the era of clicking “I agree” on just about every terms-of-service agreement, remember to read your loan documents carefully. Your loan document is packed with details and requirements for your business. Ignoring what’s expected of you is a loan mistake that could lead to a recall of the loan.
Understanding a loan agreement comes down to simple awareness. Before you sign, ask your lender questions. If you’re struggling to follow the more technical aspects, review the agreement with an attorney or an experienced business owner. Here’s what to know as you prepare to sign on the dotted line. [Read related: How to get a bank loan]
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What is a loan agreement?
A loan agreement is a document, signed by both the lender and the borrower, that spells out the terms of the loan. These agreements are binding and can be simple or complex. The loan agreement lays out the repayment schedule, the costs to the borrower, and other rules or requirements. Loan agreements must follow state and federal guidelines to protect the borrower from excessive interest rates or loan fees.
Why is a loan agreement necessary?
A loan agreement is an extremely important part of borrowing money. Without one, neither party is protected if they run afoul of the loan terms. Here are some of the reasons you need a loan agreement:
- There’s no ambiguity. The loan agreement spells out the details of the loan, including the repayment terms, interest rate and fees. This way, everyone knows what’s expected of them.
- It prevents changes. Without a loan agreement, your lender could raise your rate or charge higher fees, and you’d be required to pay. On the flip side, it protects the lender if a borrower is late with a payment or defaults on the loan.
- It helps you negotiate the best deal. The devil is in the details, and that’s particularly true when you’re negotiating a loan. A loan agreement lists the fees you can potentially eliminate, such as an application fee, a monthly maintenance fee or a prepayment penalty.
- It’s your proof. The loan agreement protects you from the IRS. It’s proof that the money you’ve obtained is a loan and not a gift that could create a tax event.
- It builds trust. Borrowing money and lending money are based on trust, said Rene Kakebeen, chief financial officer at JEi, Corporate Services. “Borrowers need to read [the agreements] and understand what they’re saying. And if they don’t understand, they should either ask the lender or go to their attorney.”
A loan agreement removes any ambiguity about the loan, protects both parties from hiked fees or missed payments, shows the IRS that the money isn’t a gift, and helps you negotiate.
What is included in a loan agreement?
Although loan agreements vary from one lender to the next, some elements are standard:
- Borrower information. This is the name and contact information of the person or business applying for the loan. It often requires photo ID.
- Guarantor information. If the borrower has a co-signer, this section of the loan agreement spells out those details.
- Transaction information. This is where all of the loan details are found. It includes the amount borrowed, the interest rate, whether the interest is compounding or simple, and the repayment terms.
- Collateral requirements. Most business 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.
[Related Content: SBA and Conventional Loan Differences]
What are the loan contract terms to review?
Beyond the borrower information and transaction details, loan agreements include the lender’s expectations of the borrower, which are broken down into positive covenants, negative covenants and reporting requirements, according to Kakebeen. These three sections outline everything the borrower can and can’t do, and they provide a framework for annual or quarterly reporting habits. These sections, and the section detailing defaults, are the areas you should scrutinize before you sign.
Below are more details on these three sections of a loan agreement.
A positive covenant details certain conditions your business must meet during your loan’s lifetime. This may include properly paying your taxes and maintaining your business insurance policies and total assets. It could also mean maintaining a certain debt-service coverage ratio (DSCR).
Your DSCR reflects your company’s ability to meet its current debt obligations based on its cash flow. A 1.25 ratio, for example, means you’ll have to cover 100 percent of your operating debt and have 25 percent of your funds left over to continue your business’s operations.
While decreased sales obviously affect your DSCR, it’s important to be aware of other factors. If you’re running a seasonal or cyclical business, for example, talk to your lender about setting up ratios that make sense for your cash flow throughout the year. Taxes and tax returns can have an impact on cash flow, to the point where it could push your DSCR below the lender’s limit, Kakebeen said. This is another indirect way you might violate the loan agreement.
“You need to talk to your CPA and say, ‘These are my requirements; I need to be at these ratios so I don’t end up in default,’” Kakebeen said.
These parts of a business loan agreement forbid your business from taking certain actions until you’ve repaid your loan. They often include the below and typically allow for exceptions.
- Debt covenants. This contract term prevents you from taking out additional debt during your loan’s lifetime. Lenders may include this term to ensure that your cash flow remains strong enough that you can repay your loan.
- Lien covenants. If a lien covenant is part of your loan contract, you can’t incur any additional liens during your loan’s lifetime. This means you can’t put up any more assets as collateral while you’re still paying off your loan.
- Asset sale covenant. This covenant prevents you from selling assets while you’re repaying your loan. Lenders often worry when borrowers sell assets since converting income-generating assets to cash permanently caps their revenue-earning potential. This, in turn, limits your cash flow, giving you less money with which to repay your loan.
- Investment covenant. You can’t make investments with your cash if this term is part of your loan contract. The cash you would use for investments instead remains free to repay your loan, thus satisfying lenders.
- Restricted payments covenant. Making equity payments to shareholders is forbidden once you sign this contract term. The same logic applies as with investments — lenders want your cash to go only toward repayment.
- Mergers and acquisitions covenants. Loan agreements may ban you from pursuing mergers and acquisitions during your loan’s lifetime. These business and ownership changes may be significant enough to affect your loan repayment ability.
The reporting requirements section outlines the financial reporting required of the borrower. You may be tempted to overlook this section.
“Many lenders have lots of reporting requirements, and borrowers tend not to read those,” Kakebeen said. “They’re more interested in getting the money than worrying about financial statements and reporting requirements.”
However, it’s important to read and understand everything, Kakebeen said. For example, the reporting requirements outline when and how to submit the loan documentation. Additionally, if you fail to meet certain reporting requirements, the bank can recall the loan, which means you’ll enter the default process.
Kakebeen said the purpose of these requirements is to provide a look into your cash flow and operations, which sheds light on debt-service coverage ratios and other important financial indicators. The documentation also allows the lender to keep an eye on your business as it grows and changes.
Getting a small business loan means ironing out exactly what you need to do to stay compliant with your lender’s terms. This allows you to obtain the loan that best fits your business’s needs and to build a relationship with your lender.
These penalties are fees the lender charges the borrower for paying off the loan before the end of the term originally set in the loan agreement. Prepayment penalties are usually outlined in the positive or negative covenants sections or have their own section.
These fees may feel like a punishment when you’ve only honored your pledge to repay the loan. However, prepayment penalties often protect lenders.
Alex Espinosa, licensed loan originator at United Northern Mortgage Bankers, said it’s important for business owners to be aware of so-called yield maintenance prepayment fees, which can be used to block business owners from refinancing at a lower rate.
“The most common reason for loan prepayment is a drop in interest rates, which provides an opportunity for a borrower to refinance,” he said in an email. “Yield maintenance allows the bank to get their original yield without any loss in a falling-interest-rate environment.”
If you understand what’s in your contract, you can avoid penalties. Moreover, Stuart Wolfe, an attorney at Wolfe & Wyman, said that lenders are usually willing to work with business owners on a few of these issues.
“Their goal is not to have a ‘gotcha’ moment and call default on the loan,” he said. “Their goal is to underwrite their risk of making this loan on whatever terms they’ve agreed with.”
What are the best business loans?
Eager to sign a business loan agreement and get the funding you need? Below are our picks for the best business loans.
- Biz2Credit is a marketplace lender, which means you can pursue several types of loans through this provider. Read our Biz2Credit review to learn more.
- Noble Funding works solely with business borrowers for whom it knows for sure it can obtain fitting loans. Learn more via our Noble Funding review.
- Fora Financial is great for dipping your toes in the water with small business loans, since short-term loans are its primary offerings. Learn more via our Fora Financial review.
- SBG Funding is also a solid pick for your first-ever loan, since this lender’s terms are reputably flexible. This means you’ll get the terms you need to avoid violating your loan agreement. Alongside traditional loans, this lender also offers business lines of credit. Read our SBG Funding review to learn more.
- com is a loan search engine that makes comparing and contrasting your loan options especially easy. Read our Businessloans.com review to learn more.
Whether you’re working with a large bank or an alternative lender, it pays to negotiate the terms of your loan.
Negotiate your loan and know the terms
Wolfe stressed that a lot of borrowers can negotiate their small business loan agreements with the lender.
“Even when you’re dealing with a large bank against a small business owner, much of it is negotiable,” Wolfe said. “They do want the business.”
If you scrutinize your loan agreement and pick out what you want to adjust, you can protect your business and ensure you stay compliant with your lender. You may want to have an attorney review your agreement before you sign.
“Whenever you get into a lending or borrowing situation, go into it with your eyes open,” Kakebeen said. “Don’t assume that everything is in your favor or that because you’re going to get the money, nothing else matters. It does matter.”
Matt D’Angelo and Donna Fuscaldo contributed to this article. Some source interviews were conducted for a previous version of this article.