Finally! You’ve been approved for a small business loan! You probably had to produce a pile of documentation, complete multiple forms, and answer lots of questions. But you’re not done yet.
One final step in the small business loan process is signing the business loan agreement. This binding document is an agreement between a business and a lender outlining the promises of both parties. The promise includes the lender giving money and the borrower repaying that money. Along with that agreement come other stipulations outlined below.
Reasons to create a business loan agreement
If you’re just starting out, you might have a standard loan agreement through a traditional lender. However, you may choose to give up some equity or control of your business in exchange. It’s very important to have a legal or financial professional review any agreement before you sign.
Buying a building
Commercial real estate loan agreements can be complex. Make sure your away of all costs, late fees, or prepayment penalties.
Buying equipment, including vehicles
For many equipment loans, defaulting results in the loss of your assets. Because the equipment secures the loan, the lender could seize those items if you fail to meet the requirements of your loan agreement. The lender could then sell that equipment to recoup some of the costs of the loan. Be aware of the terms and able to make all payments on time for the life of the loan.
Buying products or parts to build an inventory or sell
Your vendor may require a loan agreement if you purchase inventory or products.
Borrowing money from a family or friend
Many a relationship has ended over borrowed money. Make sure you have an agreement in place before you borrow from someone you know. Outline expectations and payback details clearly.
7 components of a business loan agreement
1. Promissory note
LegalZoom writes that promissory notes may also be referred to as an IOU, a loan agreement, or just a note. It's a legal document that says the borrower promises to repay to the lender a certain amount of money in a certain time frame. This kind of document is legally enforceable and creates a legal obligation to repay the loan.
2. Security agreement
When you take out a loan, the borrower sometimes has to put up property as “collateral.” Collateral is property that secures the loan. If the borrower defaults, the lender can take the property and apply the proceeds to the debt. In order to secure a loan, you will need to sign a security agreement. A comprehensive security agreement should identify the property in detail that acts as collateral.
3. Interest rate
An interest rate is a percentage that reflects the cost of borrowing the loan amount. Interest rates can be variable or fixed, depending on if they change throughout the term of the loan. The interest rate depends on the type of loan, the borrower’s credit score and if the loan is secured or unsecured.
4. Affirming statements
As the borrower, you will be asked to affirm that certain statements are true. Statements might include your assurance that the business is legally able to do business in the state, that the business has filed all its tax returns and paid all its taxes, that there are no liens or lawsuits against the business that could affect its ability to pay back the loan, and that the financial statements of the business are true and accurate. Statements may vary from lender to lender.
5. Personal guarantee
A personal guarantee as related to a business loan is an agreement you sign that authorizes a lender to use your personal assets to pay back a loan if your business can’t pay back the loan. Personal assets might include your house, car, savings or retirement fund.
6. Prepayment penalty
Some people like to pay down debt as soon as they can. A prepayment penalty is a fee that lenders charge to borrowers who pay off loans early. Loans are typically scheduled to last for a certain number of years, with the loan balance reaching zero at the end of the term. For example, a Bank Term loan might have a payback term of 5 years and an SBA 7(a) loan has a payback of 10 years. If you payback early, you might have to pay a penalty. (SBA 7(a) Working Capital and Debt Refinance loans as well as Bank Term loans through banks in the SmartBiz network have no prepayment penalties. You can pay off your loan any time with no additional cost)
7. Late payment penalty
A late payment penalty is standard with most loans and will likely be covered in your small business loan agreement. A late payment fee may be charged as a flat fee or as a percentage of your missed payment. To avoid this fee, make payments on time as agreed upon.
Terminology in a business loan agreement
Here are terms you may come across in a loan agreement.
- Amortization - This is debt paid off through equal periodic payments made at the end of a fixed period.
- Annual percentage rate (APR) - This is the rate reflecting the amount of interest earned or charged.
Balloon payment. This is a payment you must make at the end of the loan term that is larger than the other installment payments you’ve made throughout the life of the loan.
- Co-signer - A person who will assume responsibility of the loan if the primary cardholder is unable to repay the balance/debt.
- Curtailment - This is a payment you make in addition to your regular payment to reduce the principal balance of the loan.
- Default - This is failure to fulfill the promise made in the loan agreement, such as failing to pay back the loan.
- Deferred payment loan - This is a loan that allows the borrower to make payments at a later date rather at signing.
- Factor rate - This is a decimal figure showing the total repayment amount, which is often associated with merchant cash advances.
- Interest-only payment loan - Rather than amortizing, you pay this loan is off with monthly payments of just interest, then you pay off the principal balance in one lump sum at the end of the loan term.
- Loan-to-value ratio (LTV) - This is the ratio of the principal balance of a loan to the value of the asset that the loan covers.
- Loan underwriting - This is the process behind the lender’s decision to make a loan based on the borrower’s credit, assets and other factors.
- Principal - This represents the amount of debt remaining on a loan, excluding interest.
- Refinancing - This is when you pay off an existing loan with a new loan.
- Servicing - This refers to loan management, including the collection of payments.