A Walkthrough of Your Business Loan Agreement

What is a business loan agreement?

Put simply, a business loan agreement is a legally binding document that states the details of a loan between a lender and borrower (usually the business owner). While every loan agreement is unique, most of them include information such as the loan amount, repayment term, due dates, interest rates, and fees. It’s essential that both the lender and borrower thoroughly read and understand the loan agreement. Otherwise, confusion about the loan and issues may arise in the future. 

Overview of a business loan agreement.

Typically, the lender compiles and provides the loan agreement. This is particularly true if the lender is a bank, credit union, or other type of formal financial institution. But if you take out a private loan from an individual, you may be responsible for the agreement as the borrower. 

Fortunately, there are many forms and templates to help you out. You can also consult a business attorney, who can guide you through the process. Regardless of if a lender takes care of the business loan agreement or you do, it’s important to understand the most common sections, including:

• Effective date: This is the date on which the loan agreement becomes binding. In most cases, this is the day the lender disburses the loan funds.
• Parties and loan amount: The business loan agreement should include the name and contact details of the lender and borrower in addition to the amount of money being borrowed.
• Promissory note: A promissory note is a promise to pay. It states that the borrower agrees to pay back the loan amount at the set interest rate, which may be fixed or variable. 
• Collateral: If the loan is secured, the loan agreement should describe the collateral. This may be commercial property, a vehicle, equipment, or any other business asset. 
• Terms and conditions: Terms and conditions refer to the installment agreement plus basic details, such as the loan amount, loan term, and interest rate. It may also explain whether prepayment is permitted. 
• Nonpayment penalties: The purpose of this section is to describe what will happen to the borrower if they miss a payment. It will likely include information about a grace period in which they can make a late payment without facing any penalties. 
• Defaults and acceleration clause: The defaults and acceleration clause explains the consequences of a loan default. It might include fines and other ramifications. 
• Governing law: Since laws vary from state to state, every business loan agreement should discuss which state law applies. An experienced business lawyer can assist with this.
• Borrower representations: The borrower is expected to make several representations. A few examples of representations are the borrower can legally operate in the state and all financial representations are accurate. 
• Covenants: A covenant is essentially a promise made between the borrower and lender. It may state that the lender agrees to disperse a certain amount of funds at a specific interest rate while the borrower agrees to pay back the loan, according to the terms in the agreement. 

Terms you may see.

Since loan agreements can get quite lengthy and complex, it’s a good idea to become familiar with common terms, such as:

• Amortization: If the loan has a fixed interest rate, loan amortization explains how it’s scheduled into equal payments over the repayment term. Each payment usually includes interest and a payment that goes toward the loan principal. 
• Annual percentage rate (APR): The APR on a loan represents the total cost of a loan and is usually expressed as a percentage. It should include interest and any applicable fees.
• Automated Clearing House (ACH): ACH payments are common in business loan agreements. They involve automatic withdrawals from the borrower’s bank account.
• Balloon payments: Most loan payments include a portion of interest accrued and a portion of the loan principal. But some business loans are set up in a way that all or part of the loan principal remains at the end of the term. In this case, you must repay one, large balloon payment. 
• Blanket lien: A blanket lien covers all of a business’ assets, rather than a particular piece of their collateral. If a borrower defaults, it allows the lender to attach to any of the borrower’s assets to recover their losses.
• Cosigner: If you have no credit or bad credit, you may apply for a business loan with a cosigner to increase your chances of approval with a good rate. Your cosigner’s information and duties should be listed in the loan agreement. 
• Default: You default on a business loan when you fail to make payments based on the loan agreement. The lender will have the right to take legal steps and recoup the balance you owe them.
• Deferred payment loan: A deferred payment loan is when you and the lender agree that payments start on a certain date in the future, rather than right away like they normally do with traditional term loans.
• Factor rate: While most business loans feature interest rates, some loans like business cash advances and invoice factoring use factor rates instead. A factor rate is typically a decimal that shows the factor of the total loan amount that will be paid back.
• Loan-to-Value (LTV) ratio: The LTV ratio refers to the portion of an asset’s value that’s covered by a loan. If you want to finance a commercial property or equipment, it will likely come into play.
• Prepayment penalty: Some lenders will penalize you for repaying your loan early. A prepayment penalty is designed to help them make up lost interest.
• Refinancing: If you refinance a loan, you take out a new loan to repay an existing loan. This strategy can help you land a lower interest rate or lower your monthly payments.
• Servicing: Loan servicing is all about how the loan is managed. It may include how loan funds are disbursed, how payments are collected and what happens if you default.

Pay attention to:

When reviewing your business loan agreement, be sure to pay attention to the following.

Proposed financing amount

First, be sure the financing amount will be enough to satisfy your business needs. This can be a double-edged sword. You don’t want to be offered financing outside your means and be on the hook for repayment, but you may need to find another option if a lender doesn’t offer you enough financing. Consider the type of financing you are applying for and how it fits into your overall financing plan. Would you have to reapply for more financing and incur additional application costs if you needed more money? Make sure the proposed financing amount makes sense to your need. 

Term length

Most financing agreements will lock you into a contract for a set length of time or until you repay the loan amount. When reading the contract, watch out for termination penalties. These costs can be quite high, so make sure you understand the penalty for ending your financing agreement. It can be a red flag when a lender wants to lock you in for a certain length of time. In a perfect world, you will stay with your lender because they are serving your financing needs. Just be aware of how long your financing agreement will last and the repercussions of ending that agreement.

Total cost of financing

This is probably the most important detail to small business owners. Sometimes the cost of small business financing is not obvious. Legal jargon and finance industry terms can be confusing to understand. Short term loans are probably more expensive than loans with longer terms, so be sure to weigh the costs when making your decision. Not only do you need to pay attention to the overall cost of the loan, but also its repayment terms. Frequent repayments could hurt your cash flow, but some loan types (like business cash advances and ACH loans) depend on weekly or even daily payments.

Hidden fees

Hidden fees are called that for a reason. You may not realize the extra costs associated with your financing agreement, even after reading the contract carefully. It’s not a bad idea to get an extra pair of eyes on the agreement to look for issues. Is there a fee for paying back the loan early? Are there fees for service or additional funding? These costs can add up, and if the lender is not upfront about additional fees, you should be skeptical. Check out the customer reviews for your lender. One bad review does not have to be a dealbreaker, but tons of bad reviews should be considered Empire State Building-sized red flags. You don’t want to be locked into a contract with a company that is going to nickel and dime you to death.

Differences in the agreement from what was discussed

A surprise birthday party is great! A surprise in a financing agreement? Not so great. If the financing agreement is full of costs and schedules that you did not already discuss with your lender, this is a red flag. You should be aware of major costs, penalties, and requirements before you even receive an agreement. Any large discrepancies between your written contract and what you discussed verbally should be addressed before you sign anything. If a lender surprises you with penalties and requirements before you have signed an agreement, this could be a bad sign.

Fit for your needs

Suppose you’ve read through the agreement, probably multiple times. There seem to be no obvious red flags or discrepancies in the document. The lender has decent customer reviews, and nothing is holding you back from signing the financing agreement. Your last question to ask is simply if the agreement makes sense for you. Is this financing option going to improve your cash flow and help you grow? Sometimes you can see only 10 feet in front of you, and you’re focusing on meeting payroll and staying alive. When you sign up for small business financing, it’s essential not just to survive, but also to know that it will help you grow. 

Small business financing without red flags.

It’s important to shop around when you are looking for financing. You want to get the best rate, financing amount, and service for your business. A solid financing partner will offer you flexibility and transparency. If there are red flags in your proposed financing agreement, call your lender and address them—there are other small business financing options available to you.