What is a Loan Agreement?
Few people sail through life without borrowing. With few exceptions, almost everyone takes a loan to buy a car, finance a home purchase, pay for a college education or cover a medical emergency. Loans are nearly ubiquitous and so are the agreements that guarantee their repayment.
Loan agreements are binding contracts between two or more parties to formalize a loan process. There are many types of loan agreements, ranging from simple promissory notes between friends and family members to more detailed contracts like mortgages, auto loans, credit card and short- or long-term payday advance loans.
Simple loan agreements can be little more than short letters spelling out how long a borrower has to pay back money and what interest might be added to the principal. Others, like mortgages, are elaborate documents that are filed as public records and allow lenders to repossess the borrower’s property if the loan isn’t repaid as agreed.
Each type of loan agreement and its conditions for repayment are governed by both state and federal guidelines designed to prevent illegal or excessive interest rate on repayment.
Loan agreements typically include covenants, value of collateral involved, guarantees, interest rate terms and the duration over which it must be repaid. Default terms should be clearly detailed to avoid confusion or potential legal court action. In case of default, terms of collection of the outstanding debt should clearly specify the costs involved in collecting the debt. This also applies to parties using promissory notes as well.
Purpose of a Loan Agreement
The main purpose of a loan contract is to define what the parties involved are agreeing to, what responsibilities each party has and for how long the agreement will last. A loan agreement should be in compliance with state and federal regulations, which will protect both lender and borrower should either side fail to honor the agreement. Terms of the loan contract and which state or federal laws govern the performance obligations required by both parties, will differ depending upon the loan type.
Most loan contracts define clearly how the proceeds will be used. There is no distinction made in law as to the type of loan made for a new home, a car, how to pay off new or old debt, or how binding the terms are. The signed loan contract is proof that the borrower and the lender have a commitment that funds will be used for a specified purpose, how the loan will be paid back and at what amortization rate. If the money is not used for the specified purpose, it should be paid back to the lender immediately.
Other Reasons for Using Loan Agreements
Borrowing money is a huge financial commitment, which is why a formal process is in place to produce positive results on both sides.
Most of the terms and conditions are standard fare – amount of money borrowed, interest charged, repayment plan, collateral, late fees, penalties for default – but there are other reasons that loan agreements are useful.
A loan agreement is proof that the money involved was a loan, not a gift. That could become an issue with the IRS.
Loan agreements are especially useful when borrowing or loaning to a family member or friend. They prevent arguments over terms and conditions.
A loan agreement protects both sides if the matter goes to a court. It allows the court to determine whether the conditions and terms are being met.
If the loan includes interest, one side may want to include an amortization table, which spells out how the loan will be paid off over time and how much interest is involved in each payment.
Loan agreements can spell out the exact monthly payment due on a loan.
It is safe to say that anytime you borrow or lend money, a legal loan agreement should be part of the process.
On Demand vs. Fixed Repayment Loans
Loans use two sorts of repayment: on demand and fixed payment.
Demand notes are usually used for short-term borrowing and are often used when people borrow from friends or family members. Sometimes banks will offer demand loans to customers with whom they have an established relationship. These loans typically don’t require collateral and are for small amounts.
Their key feature is how they are repaid. Unlike longer term loans, repayment can be required whenever the lender desires, as long as sufficient notification is given. The notification requirement is usually spelled out in the loan agreement. Demand loans with friends and family member might be a written agreement, but it might not be legally enforceable. Banks demand loans are legally enforceable. A check overdraft facility is one example of a bank demand loan – if you don’t have the money in your account to cover a check, the bank will loan you the money and pay the check, but you are expected to repay the bank quickly, usually with a penalty fee.
Fixed term loans are commonly used for large purchases and lenders often demand that the item purchased, perhaps a house or a car, serve as collateral if the borrower defaults. Repayment is on a fixed schedule, with terms established at the time the loan is signed. The loan has with a maturity date when it must be fully repaid. In some cases, the loan can be paid off early without penalty. In others, early repayment comes with a penalty.
Legal Terms to Consider
All loan agreements must specify general terms that define the legal obligations of each party. For instance, the terms regarding repayment schedule, default or contract breach, interest rate, loan security, as well as collateral offered must be clearly outlined.
There are some standard legal terms involved in loan agreements that all sides should be aware of, regardless of whether the contract is between family and friends or between lending institutions and customers. Here are four key terms you should know before signing a loan agreement:
Choice of Law: This term refers to the difference between laws in two or more jurisdictions. For example, the laws governing a specific part of a loan agreement in one state may differ from the same law in another state. It is important to identify which state (or jurisdiction’s) laws will apply. This term is also known as a “Conflict of Law.”
Involved Parties: This refers to personal information about the borrower and lender that should be clearly stated in the loan agreement. That information should include the names, addresses, social security numbers and phone numbers for both sides.
Severability Clause: This term states that terms of a contract are independent of each other. Thus, if one condition of the contract is deemed unenforceable by a court, that doesn’t mean all conditions are unenforceable.
Entire Agreement Clause: This term defines what the final agreement will be and supersedes any agreements previously made in negotiations, whether written or oral. In other words, this is the final say and anything that was said (or written) before, no longer applies.
Interest Rate Determination
Many borrowers in their first experience securing a loan for a new home, automobile or credit card are unfamiliar with loan interest rates and how they are determined. The interest rate depends on the type of loan, the borrower’s credit score and if the loan is secured or unsecured.
In some cases, a lender will request that the loan interest be tied to material assets like a car title or property deed. State and federal consumer protection laws set legal limits regarding the amount of interest a lender can legally set without it being considered an illegal and excessive usury amount.
If the loan includes interest payments, as most do, the terms will be spelled out in the loan’s terms and conditions. Interest is either fixed fee or floating fee.
A fixed fee, or fixed rate, loan establishes an interest rates that remains unchanged during the repayment of the loans. If you borrow money with a 4% annual rate, you will pay the lender 4% a year on the balance due until the loan is paid off. The amount of interest you pay will decrease over time as the balance is paid down and the principal payment will increase. If you borrow $200,000 to buy a house, the monthly payment will remain constant, but the portion of the payment that goes to interest and principal will change each month as the loan is balance is reduced.
Floating fee interest rates, also called variable rate loans, carry interest rates that change over time. The amount of interest based on a benchmark rate, usually a widely followed index like the LIBOR that changes regularly. Floating fee rates are adjusted periodically and generally are only used in complex loans like adjustable-rate home mortgages.
Contract Length & Amortization
The length of a loan contract is determined by a lender’s reliance upon an amortization schedule. Once the lender and the borrower have determined the amount of money needed, the lender will use the amortization table to calculate what the monthly payment will be by dividing the number of payments to be made and adding the interest onto the monthly payment.
Unless there are certain loan conditions that penalize the borrower for early loan payment, it is in the best interest of the borrower to pay back the loan as quickly as possible. The faster the loan debt is retired the less money it costs the borrower.
Pre-Payment Fees and Penalties
While the goal to pay back a loan quickly is a financially sound practice, there are certain loans that penalize the borrower with pre-paid fees and penalties for doing so. Prepayment penalties are typically found in automobile loans or in mortgage subprime loans. They also can occur when borrowers choose to refinance a home or auto loan.
Pre-payment penalties are applied to protect the lender, who expects a certain return on his loan over a certain amount of time. For example, if the borrower repays a 5-year loan in three years, the lender would be out the interest he expected the last two years of the loan.
Prepayment penalties usually are 2% of the amount due on the loan or six months of interest payments. It can have a dramatic effect on the cost of refinancing a loan. Many sub-prime loans include prepayment penalties, which opponents say target the poor, who usually are the ones with subprime loans.
On the other side are homes financed through government-backed FHA loans. Federal law specifically forbids prepayment penalties on FHA loans. The exception is if the borrower has a mortgage that contains a due-on-sale clause and the clause has been allowed as part of the mortgage.
Breach or Default
If a loan contract is paid off late, the loan is considered in default. The borrower can be liable for a myriad of potential legal damages to compensate the lender for any losses suffered.
The breached or defaulted lender can pursue litigation and have a court hold the borrower liable for legal costs, liquidated damages and even have assets and property attached or sold for repayment of the debt. In addition, a breach or default of court judgment can be placed on the borrower’s credit record.
Mandatory arbitration is an increasingly popular provision in loan agreements that requires parties to resolve disputes through an arbitrator, rather than the court system.
More than 50% of lending institutions include mandatory arbitration as part of their loan contracts because it is supposed to be faster and cheaper than going to court. Arbitration puts the final decision in the hands of one person, who likely is more experienced and sophisticated about the law than six jurors in a courtroom.
In most cases, mandatory arbitration clearly favors the lenders, who have legal counsel that specialize in this area of law on their side. The borrower often has no lawyer or inadequate representation because lawyers are not guaranteed payment in arbitration cases.
The borrower is at an even bigger disadvantage if the arbitration is binding, meaning there can be no appeal. The rules in the Fair Credit Reporting Act and the Truth in Lending Act have no bearing in arbitration cases, which also favors the lender.
Members of the military are especially vulnerable to loan agreements that include mandatory arbitration. A solider serving out of the country may not be able to attend or have competent representation at an arbitrary hearing and because of that, lose possession of a car or other asset. The arbitrator’s decision can’t be appealed, so there is no recourse if the decision goes against the soldier.
Before you sign a loan agreement, read it closely and if it includes a mandatory arbitration clause, decide whether you are comfortable with that as a means of settling disputes.
Usury and Predatory Protections
Several federal and state consumer protection laws protect consumers against predatory and usury loan tactics used by lenders. The Truth In Lending Act, Real Estate Settlement Act and the Home Owners Protection Act federally protect borrowers against predatory lenders.
Many states enacted companion consumer predatory and usury protection acts to protect borrowers. Both parties benefit because lenders make reasonable interest repayment rates and borrowers receive a much-needed loan.
Several federal and state consumer protection laws protect consumers against predatory and usury loan tactics used by lenders.
Promissory notes resemble loan agreements but lack complexity. Often, they are little more than commitment-to-pay letters like IOUs or simple payment on demand notes. Usually the borrower writes a letter specifying how much money he or she is borrowing and the terms under which it will be repaid. They are almost always used for small loans between people who know one another well.
Promissory notes are signed and dated and can be legally binding. Promissory notes can be secured or unsecured. Secured loans offer the lender collateral is the loan isn’t repaid, while unsecured loans don’t use collateral. They can contain terms about installment payments and interest, though they might not.
Unlike loan agreements, which can contain complex payment terms, promissory notes are more like paper trails that document that one person has lent another money and that the borrower agrees to repay the money within a certain amount of time, either in a lump sum or in installments. It’s used primarily to avoid financial misunderstandings and shouldn’t be confused with a loan agreement, which contains an assortment of legally enforceable terms and remedies.
About The Author
Bill “No Pay” Fay has lived a meager financial existence his entire life. He started writing/bragging about it in 2012, helping birth Debt.org into existence as the site’s original “Frugal Man.” Prior to that, he spent more than 30 years covering the high finance world of college and professional sports for major publications, including the Associated Press, New York Times and Sports Illustrated. His interest in sports has waned some, but he is as passionate as ever about not reaching for his wallet. Bill can be reached at [email protected].
- NA, (2016, June 24) What is the Difference Between an IOU, a Promissory Note and a Loan Agreement? Retrieved from: https://legaltemplates.net/blog/difference-between-iou-promissory-note-loan-agreement/
- Parish, V. (2015, November 8) Difference Between a Term Loan and a Demand Loan. Retrieved from: http://www.letslearnfinance.com/difference-between-term-loan-and-demand-loan.html
- Use Promissory Notes when Lending to Family and Friends. Retrieved from: http://public.findlaw.com/consumer/promissory-notes.html
- NA, (2014) Severability. Retrieved from http://www.contractstandards.com/clauses/severability
- NA, (2014) Entire Agreement. Retrieved from http://www.contractstandards.com/clauses/entire-agreement