- 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, it's important to read your loan documents carefully. Unlike technology privacy policies or other service contracts, your loan document is packed with details and requirements for your business. Ignoring what's expected of you is a loan mistake and could lead to a recall of the loan.
It may be a common belief that banks hide nefarious terms throughout loan agreements to play "gotcha" with business owners, but 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 it with an attorney or an experienced business owner.
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Borrowing money and lending money are based on trust, said Rene Kakebeen, a lending specialist who provides loans for small businesses. "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."
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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.
Key takeaway: A loan agreement spells out the details of the loan, including the amount, interest, and terms.
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. There are several reasons why 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 it comes to 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.
Key takeaway: 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, they have some standard elements:
- 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.
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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.
Taking out a loan means more than just meeting your payments each month.
Borrowers think in terms of repaying their debt, said Stuart Wolfe, an attorney at Wolfe & Wyman who handles finance loan agreements, but "the terms seep into much larger issues in your company's affairs."
Loan terms can apply to aspects such as changing ownership (even if the business is being passed on to a family member) or business insurance, or making the lender your primary bank for the duration of the loan. Some terms even extend beyond the primary company to its subsidiaries, according to Wolfe.
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 get the loan that best fits your business's needs and to build a relationship with your lender.
Key takeaway: When you're reviewing the contract terms of the loan agreement, pay attention to the lender's expectations, including the positive covenants, negative covenants, and reporting requirements.
What are the reporting requirements for a loan?
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. Pay attention to the quality of this documentation as well, he said, as there's a big difference between a company-prepared financial statement and a fully audited financial statement.
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.
Don't assume that this process is finished once the lender has approved the loan, Kakebeen said; in some instances, your lending officer may ask for additional information and financial documentation.
Debt-service coverage ratio
One metric the financial reporting reveals to the lender is whether you're maintaining the correct debt-service coverage ratio (DSCR), or a 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% of your operating debt and have 25% of your funds left over to continue your business's operations.
These ratios are outlined in the loan agreement, usually in the positive covenants section, according to Wolfe. 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, you'll want to talk with 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.
Key takeaway: Lenders require you to maintain a certain debt-service coverage ratio throughout the life of the loan. If it falls below the agreed-upon ratio, you've violated the loan terms.
Prepayment penalties
Prepayment 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. Wolfe said it's important for business owners to consider that, if the loan is the primary line of credit or type of financing, it's likely a big sum for the lender.
The lender counts on the loan to be fully amortized (which means both the principal and the interest are paid off) over the entire term – for example, 10 years. If the lender is expecting 10 years of principal-and-interest payments and you pay off your loan in four years, it misses six years of extended profit, Wolfe said.
"Part of the value of the loan is having a long-term extension of credit – from their [the lender's] point of view – at a certain interest rate," he said. "They're going to sell that loan; they're going to use that loan as an asset performing at a certain interest rate. They've lost the rights if it's paid off early."
The nature of prepayment penalties may not be inherently bad, but if you don't address or understand the structure of these fees, they could end up hurting you. Alex Espinosa, a Small Business Administration lending consultant and founder of Bold Lender, 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."
While this is a relatively common banking practice, Espinosa said, small businesses may not realize how high these fees can be. If you understand what's in your contract, however, you can avoid the penalties. Moreover, Wolfe said, 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."
Key takeaway: Prepayment penalties are fees that some lenders charge if you pay your loan back early. It's important to review the loan agreement to see what these terms may be.
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."
By scrutinizing your loan agreement and picking out what you want to adjust, you can protect your business and ensure you stay compliant with your lender. It can help 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."
Key takeaway: Whether you're working with a large bank or an alternative lender, it pays to negotiate the terms of your loan.
Donna Fuscaldo contributed to the writing and reporting in this article. Some source interviews may have been conducted for a previous version of this article.