How to Read Your Business Loan Agreement

Business Loan Agreements Explained

Understanding Your Business Loan Agreement

Congratulations on securing a small business loan! However, it’s crucial to fully understand the terms of your business loan agreement. This document outlines the contract between you, the Business Loan owner, and the lender. Although these agreements can be complex, understanding them — especially key elements like Personal Guarantees  is vital for your business’s success.

Importance of Understanding Business Loan Agreement Terms

Understanding the legal jargon in your loan documents is essential because you are legally binding yourself and your business to specific terms and conditions. These terms will govern and potentially limit your Business Loan operations until the loan is repaid. Defaulting on any clause can have serious consequences, and default doesn’t always mean missing a payment. A solid grasp of your loan’s terms will help you make informed financial decisions, choose between lenders, and manage your cash flow effectively.

Key Terminology to Know

Amortization

Amortization involves paying off your loan through regular payments over time. Your amortization schedule details how much of each payment goes towards the principal and interest. For balloon loans, payments cover only interest, with the principal due in a lump sum at the end. Fixed-rate loans gradually increase the principal portion of each payment, while straight-line amortization maintains consistent payments throughout the loan term.

Principal

The principal is the original amount borrowed or the remaining debt. For example, if you borrow $10,000, that is your principal. After several payments, this amount will decrease over time.

Annual Percentage Rate (APR)

APR includes both the simple interest rate and all fees associated with your loan, providing a more accurate representation of the loan’s total cost compared to a simple interest rate. It reflects the true cost of borrowing.

Co-Signer

A co-signer agrees to take on responsibility for the loan if you cannot repay it. This person should understand all loan terms, as they are equally liable for the debt.

Curtailment

Curtailment refers to making extra payments towards the principal in addition to your regular payments. Be aware of any prepayment penalties that may negate the benefits of paying off the loan early.

Interest-Only Payment Loan

An interest-only payment loan requires payments solely towards interest, with the principal due in a lump sum at the end of the term. This type of loan may offer lower monthly payments but can be risky if you can’t repay the principal when it comes due.

Deferred Payment Loan

A deferred payment loan allows you to start payments at a later date, providing a grace period. However, this will increase your monthly payments once you begin repayment.

Loan to Value (LTV) Ratio

LTV is the ratio of the loan amount to the value of the asset being financed. For example, if a lender funds 80% of the asset’s value, you must cover the remaining 20% yourself.

Factor Rate

A factor rate expresses the total repayment amount as a multiple of the principal. For instance, a factor rate of 1.5 on a $10,000 loan means you will repay $15,000 in total.

Servicing

Servicing includes the costs associated with managing your loan, such as customer service, processing payments, and handling paperwork. Your agreement may include terms regarding servicing fees.

Components of a Business Loan Agreement

Promissory Note

The promissory note contains core details about the loan, including the amount borrowed, term, interest rate, and payment schedule. It also specifies the effective date and when payments begin.

Security Agreement

If you’ve pledged collateral, the security agreement details the assets securing the loan. This may also involve signing a UCC-1 form to place a lien against the pledged assets.

Interest Rate

The interest rate, detailed in the promissory note, can be fixed or variable. A fixed-rate loan has a constant interest rate, while a variable-rate loan adjusts based on a reference rate like Prime or LIBOR.

Conditions

This section outlines the “if, then” scenarios, such as what happens if the loan is in default for a specific period. It defines the lender’s rights in various situations.

Items to Watch in the Fine Print

Personal Guarantee

A personal guarantee holds you personally liable for the loan. Even if your Business Loan is an LLC or corporation, a personal guarantee could result in the lender seizing personal assets if you default.

Cross-Default Provision

This clause allows a lender to consider all your loans with them in default if you default on one. It’s important if you have multiple loans with the same lender.

Prepayment Penalty

A prepayment penalty protects the lender’s profit if you pay off the loan early. It can be a lump sum or a percentage of the lost profit. Avoid loans with this penalty if you plan to repay early.

Late Payment Penalties

Check for penalties related to late payments. Some agreements may impose additional fees or increase the interest rate if payments are missed. In some cases, default could result in immediate action from the lender.

Definition of Default

This clause specifies what actions or conditions will trigger a default. It may include late payments, negative account balances, or other breaches of the loan agreement.

Restrictive Covenants

Restrictive covenants may limit your business activities, such as paying dividends or repurchasing shares, until the loan is repaid. They ensure the lender’s priority over other financial obligations.

Financial Reporting Requirements

For higher-value loans, lenders may require regular financial reports to monitor your business’s financial health. These reports may need to be audited, adding to the overall cost of the loan.

Representations of the Borrower

These statements confirm that you have provided accurate information and that you are authorized to take out the loan. They reaffirm your compliance with conditions set before the loan approval.

Red Flags When Signing a Business Loan Agreement

Requests for Money Upfront

Be cautious if a lender requests payment for interest or fees upfront. Fees should be deducted from the loan capital, not paid out of pocket.

Changed Terms

Verify that the loan terms match what was initially agreed upon. If terms or fees have changed, ask for clarification and consider seeking advice before signing.

Rushed Process

Take your time to read and understand the business loan agreement. Reputable lenders will allow you sufficient time to review the documents.

Worries About Repayment

Ensure you have a clear plan for repaying the loan. Avoid borrowing if the loan terms create too much risk for your Business Loan Agreement.

Negotiating Loan Terms

Common Negotiable Terms

Before signing, negotiate terms such as interest rates, fees, repayment plans, and personal guarantees. Your ability to negotiate may depend on your creditworthiness and the lender’s policies.

Flexible Repayment Plans

Some lenders offer flexible repayment options that align with your business’s cash flow. Explore options that match your financial situation.

Consequences of Violating Business Loan Agreement Terms

Violating business loan agreement terms can have severe consequences, including asset seizure, damage to your credit, and potential harm to your Business Loan reputation. Ensure you understand the full implications of your loan agreement and how to avoid default.

Simplified Checklist Before Signing

1. Understand Terms and Conditions: Know the loan amount, payment schedule, and overall cost.
2. Check Interest Rate or Fee: Confirm that it matches any pre-approval or verbal agreements.
3. Understand Repayment Plan: Be aware of payment start dates, schedules, and amounts.
4. Review Fine Print: Look out for any red flags or unusual clauses.

Taking the time to thoroughly review and understand your business loan agreement can protect you from unfavorable terms and ensure your business’s financial health.