Finally! You’ve been approved for a small business loan! You’ve already probably had to produce a pile of documentation, complete multiple forms, and answer lots of questions,but you’re not quite 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 comes some other stipulations outlined below:
What is a business loan agreement?
A business loan agreement establishes the terms and conditions for the loan, serving as a guide while you pay off your debt. It’s a legally binding contract between the borrower and the funding entity – whether that be a bank, family member or nontraditional platform.
Reasons to consider signing a business loan agreement
Taking on additional funds is a big decision. But the old adage “it takes money to make money” rings true for small businesses. Proceeds from the right small business loan can be used for working capital, debt refinance, marketing, hiring, and more. If you’re facing any of the business building initiatives below, signing on the dotted line can set you up for success.
Starting a business
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 you’re aware 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 purchases 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 make sure you protect your equipment by making 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.
What to avoid in a business loan agreement
It’s in everyone’s best interest that you have a loan with terms that fits your needs, keeps your business healthy, and allows you to make payments on time for the life of the loan. Before signing a loan agreement, look out for these red flags.
Variable rates
A variable rate loan means your small business can borrow money at an interest rate that may go up or down over time. For example, if the base rate rises by 0.5%, the rate on your loan will rise from 8% to 8.5%.
Pros of a variable rate loan
Variable rate loans tend to have more competitive interest rates than fixed rate loans.
If the base rate goes down, it’s likely your lender will reduce the rate on your small business loan, meaning your total amount payable and your monthly payments will lower, improving your cash flow.
Cons of a variable rate loan
If the interest rates go up, your loan’s interest rate will go up as well. If the interest rates go up, this could impact your budgeting and operational expenses, especially if you have a tight cash flow.
Unmanageable debt
When you enter into a loan agreement, you should go into it knowing how much debt your business can take. It’s important to review your business plan to determine if your use of funds will produce the money you need to pay off the loan plus interest. You should also consider how your business will be impacted if circumstances cause you to miss loan payments.
Failure to negotiate
Even when you're dealing with a large bank, some aspects of your loan can be negotiated to get a price break or a more favorable payback schedule, as the banks do want your business.
It can help to have an attorney review your agreement before you sign.
Sections of a business loan agreement
Here are the various elements of a loan agreement. Get familiar with each step to avoid possible surprises.
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. For additional details about collateral, review this post from the SmartBiz® Small Business Blog: Collateral Requirements for Small Business Loans.
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 pay back 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. Keep these handy to help clear up questions you may have.
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 than 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 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.
Final thoughts
Strive to work with a lender that has top-notch customer service. You’ll probably have questions about the process and the lender you work with should be reachable and responsive via email, phone, online chat – ideally all three. You can vet a potential lender through online sites that feature reviews from actual customers.
The SmartBiz Loans team helps small business owners across America every day secure the funds they need to thrive. We understand that small business owners need transparency and honesty when going through the loan application process.
