When to Use a Loan Agreement
A Loan Agreement, also known as a Term Loan, Demand Loan, or a Loan Contract, is a contract that is used to document a financial agreement between two parties, where one is the lender, and the other is the borrower.
It specifies the amount of the loan, what the interest on it will be, what the repayment plan is, and payment dates so that both the borrower and lender have a clear outline of the terms of the loan.
Term Loans are often divided into three types:
Business to business loan agreement: This is when one business, for example, a bank, lends money to another business such as a startup or small business.
Business to individual loan agreement: This is when a business, such as a real estate lender, provides a loan to an individual, such as a mortgage to a homebuyer.
Individual to individual loan agreement: This is when one person privately lends money to another, such as his or her family member or friend.
Understanding a Term Loan:
When one party lends a large sum of money to another, it is beneficial to have a Loan Agreement so that both parties are protected and understand the terms of the debt terms and repayment.
Prior to creating a Loan Agreement, the lender should decide what the terms of the loan will be, including the interest rate, payment due dates, and if there will be any collateral or security provided by the borrower.
How to determine an interest rate:
Look into current interest rates at financial institutions to determine a fair percentage of interest to charge the borrower. Calculate what that will amount to on its own and add it to the monthly payment amount.
How to determine payment amount:
Generally, term loans are for a set number of months or years. If payments are due on a monthly basis, divide the full amount of the loan by the number of months the borrower has to pay it off. Add the monthly interest charge to that amount.
How to determine a repayment plan:
When creating a Loan Agreement, it is important to designate the length and terms of the loan. That means deciding when the loan will be fully repaid, and when and how often payments are due.
What is collateral?
Collateral or security is what allows the lender to receive compensation even if the borrower fails to mean the terms within the Loan Agreement. For example, a borrower could provide a vehicle as collateral to the lender. If the borrower fails to make payments, the lender may, after receiving permission from the court, seize the borrower's collateral in order to replace some or all of the money that was lent.
Collateral is most often used when there is a high risk that the borrower will default on the payment terms, a significant amount of money is being lent, or where the money borrowed is used to purchase the collateral.
Once a payment amount, interest rate, collateral, and payment schedule have been decided, it's up to the borrower to meet the terms of the repayment plan as outlined in the Loan Agreement. In some cases, if a borrower fails to make a payment, the interest rate will be increased for the remainder of the term.