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Taking out a business loan means taking on a burden for your business. Yes, it gives you the cash in hand that you need now. But it also gives you a responsibility to repay what you borrowed, usually plus interest and fees. As a result, it’s important to know what you’re getting yourself into. That’s where a business loan agreement comes in.
The loan agreement is a document that lays out all the key details concerning the loan, from the term (how long you have to pay it off) to the collateral you put up to secure the loan. You need to understand every aspect of your business loan agreement clearly before signing and committing your company to its terms. This guide should help.
What is a business loan agreement?
A business loan agreement is a legal document between you and your lender, whether that’s a bank, credit union, online lender or even a family member. It serves both parties by clarifying everything about the loan, including its repayment schedule and any collateral that secures it.
The specifics the lender will put in your loan agreement depend on your company’s financial standing, from its credit score to its annual revenue. Be advised that your loan comes at a cost — from interest to fees. Your loan agreement should make those costs crystal clear.
How does a business loan agreement work?
These agreements are legally binding contracts. That means that if you don’t hold up your end of the bargain (repaying the loan), they give the lender ability to pursue compensation. In most cases, that means seizing any collateral you put up to secure the loan.
The business loan agreement comes into play after you apply for the loan, and the lender completes underwriting (evaluates your company’s fitness for the loan) and approves the financing. Most established business lenders create the loan agreement, then send it to you for review.
If you’re having a hard time getting a loan, you might explore alternatives like a loan from a friend or family member. If a person or entity lending you money doesn’t create the business loan agreement, you should do it yourself.
This documentation is key in setting expectations and avoiding confusion (and potentially even lawsuits). If you need to create your own agreement, you can start with a business loan agreement template. Then, have an attorney review it before you or the lender signs.
What’s included in a business loan agreement?
If you looked up a business loan agreement template, you already know that these documents are usually multiple pages with several distinct sections. Most loan agreements include sections on:
The effective date
From this date forward, your loan agreement becomes legally binding. Usually, this is the same date you get the loan proceeds from the lender.
The promissory note
This is basically your IOU — your promise (hence the name) to repay the lender what you borrowed plus interest.
Terms and conditions
The terms and conditions of a loan agreement are generally fairly meaty. They lay out key details like:
- The amount of the loan
- How long you have to repay it
- When you’ll make repayments
- How much you’ll pay in interest and fees
- Whether or not your lender offers a grace period for late payments
Some portion of your business loan agreement should clearly explain any penalty fees you can incur. This might have its own dedicated section or fall under terms and conditions.
Specifically, you should look for two potential penalties:
- Nonpayment. You’ll pay this fee if you miss a payment to your lender. Figure out how much it is and if you have a grace period or if this penalty kicks in immediately.
- Prepayment. Some lenders monetarily penalize businesses that repay their loans ahead of schedule.
Most business loans are secured, meaning your company puts up collateral that the lender can seize if you don’t repay what you borrow. Usually, that’s tangible assets like equipment or inventory.
In some cases, you might need to also need personal guarantee to get a business loan. If so, the business loan agreement will explicitly state that you’ve made this guarantee. With that in the agreement, the lender can pursue your personal assets if your business can’t make good on what it borrowed.
The lender may have certain stipulations around the loan. The covenants section will lay those out. Common covenants include using the loan proceeds in a certain way, not taking on more debt until the loan is repaid and staying current on your tax payments and business insurance coverage.
This section explains two key things: when the lender considers you to have broken the loan agreement and what happens at that point.
Many lenders have a grace period for late payments, but if you pass that period, you’re considered to be in default.
The default section of business loan agreements often includes an acceleration clause. This clause says that once you reach default, the lender can accelerate your repayment and demand full repayment. At that point, if you can’t pay up, the lender can seize anything you put up as collateral.
Terms to know
To help you make sense of your business loan agreement, you can use this glossary of terms that lenders commonly use:
- Acceleration. If your loan agreement contains this clause, it means that once you enter default, your lender can ask for the full loan amount to be repaid immediately.
- Amortization. This means paying off your loan in planned installments, usually with a monthly payment of a set amount. The payment first goes toward any accrued interest, and the remainder applies to the loan principal.
- Annual percentage rate (APR). This is the per-year cost of the loan, including interest and fees.
- Balloon payment. Some loans (be wary of them) come with a large, lump-sum payment you’ll need to make at some point, usually later in the repayment schedule.
- Blanket lien. This gives your lender the right to seize any business asset as repayment if you default on the loan.
- Co-signer. If someone else is taking out the loan with you (e.g., a business partner), the business loan agreement should list them as a co-signer.
- Cross-default provision. If you have multiple loans with one lender, this essentially says that if you default on this specific loan, the lender will consider you in default on all of your loans with them.
- Default. This means you’ve failed to live up to the loan agreement by not repaying what you borrowed on the agreed-upon schedule.
- Principal. The principal represents the remaining loan balance and decreases as you pay back what you borrowed. In your loan agreement, the principal should equal the money you’re getting from the lender minus any initial fees like an origination fee.
What to do before signing a business loan agreement
Getting a business loan means dealing with a lot of documents. After all of the paperwork, you might be tempted to skim the loan agreement. Don’t. If you do, you could find your business on the hook for unexpected costs like balloon payments or fees.
Before you sign, make sure you:
- Read the fine print. Go through the loan agreement line by line. Highlight or otherwise flag any sections you don’t understand (we’ll show you want to do with those next).
- Confirm that it lays out what you expect. Compare the loan agreement against what the lender initially advertised to you. Make sure you’re getting the same interest rate, fees and repayment schedule as anticipated.
- Get your questions answered. Ask your lender about anything in the business loan agreement that didn’t make sense to you. The loan officer wants to close the loan (it plays into their compensation), so they should be willing to talk you through and answer your questions.
- Consult a business attorney. That said, you shouldn’t rely exclusively on the lender. Hiring a business attorney to review the loan agreement shouldn’t be a huge expense, and it can help you avoid committing your company to a less-than-favorable situation.
- Check for red flags. Ideally, you vetted your lender before you applied for the loan and steered clear of any lenders that promised guaranteed approval or asked for money upfront. Even so, you should continue to evaluate your potential lender before entering into a legally binding agreement with them. Read their reviews and look for unexpected elements in your loan agreement.
The bottom line
Even if you think you’ve found the best small business loan possible, don’t sign just yet. Carefully review the business loan agreement to ensure you’re not committing your company to something you didn’t expect. Getting a business attorney involved can help you fully understand the terms of the loan agreement.
Frequently asked questions
This loan agreement is the legal contract that guides your business loan and binds you and the lender to its terms.
In most cases, your lender will create the loan agreement. If you’re getting a loan from an individual, though, and they don’t offer this agreement, you should create one yourself. Start with a business loan agreement template, then have a business attorney review it.
Before you sign, you should have complete clarity about how much money you’re getting from the loan, the repayment schedule for it and the cost of the loan, including interest and fees. You should also know about potential penalties and what happens if you default. The business loan agreement should answer all of those questions for you.