What is a loan agreement?
A loan agreement or loan contract is an agreement between two parties, the lender and the borrower. The lender agrees to lend money and the borrower agrees to pay it back, usually with interest.
Secured and Unsecured
Loans can be secured or unsecured. A secured loan is where the borrower puts up their assets as security (back-up) for the lender. This means that if the borrower does not pay back the money they borrowed (i.e. defaults on their obligations under the loan agreement), the lender can take possession of the assets and sell them to get their money back.
An unsecured loan is a loan where there are no assets providing security. This means that if the borrower does not pay back the money it borrowed from the lender then there are no assets that belong to the borrower that the lender can sell to recover the money they loaned to the borrower. Unsecured loans are more risky for lenders because it is more difficult for them to make sure they will get their money back.
Loans can also be guaranteed. This is where a second person also signs the loan and agrees to pay back the amount the borrower borrowed if the borrower does not pay it back. This situation is most often used where a parent signs as a guarantor when their child is getting a loan (say a car loan) and the child has not been out in the workforce very long.
Key Terms of a Loan Agreement
Loan agreements are often complicated documents. Some of the key terms that will be included in the agreement are:
- The purpose of the loan – Most loans have a specific purpose – i.e. the money lent can only be used for the purpose specified. Loans without a specific purpose are riskier for lending institutions and often attract a higher interest rate as a result.
- Loan clause – This will state when and how money will be loaned to the borrower. It will state whether there are any conditions the borrower needs to satisfy before the money is advanced.
- Interest – Interest on a loan might be fixed for the duration of the loan, fixed for a certain amount of time or variable. The loan agreement will also include how often the interest is calculated and applied to the amount owing.
- Fees – A clause will state whether there are any other fees associated with the loan.
- Guarantee or security – The lender may require security for the loan or that someone signs on as a guarantor.
- Repayment – Usually repayments are due over a fixed term and schedule (e.g. monthly). However sometimes loans are made on an on-demand basis which means that the lender can require their money repaid at anytime.
- Interest only or principal and interest repayments – The loan will stipulate the amount of the repayments, including whether the borrower has to pay off the interest only or whether they have to make payments against the amount loaned as well (the principal).
- Default interest – Sometimes there is extra interest payable if the borrower misses or is late on a repayment.
- Event of default – This clause will explain what will happen if the borrower fails to pay or doesn’t meet their obligations under the loan.
- Covenants – The loan agreement may have covenants included, for instance the lender may require the borrower to agree to do or not do certain things (for instance there may be a covenant prohibiting the borrower from getting another loan).
- Representations and warranties – The borrower generally has to agree that the information they have provided is complete and correct. There can be big consequences for misrepresenting your financial situation.
Defaulting under a loan agreement
There are some other terms that are important to understand in a loan agreement. Firstly, a default on the loan isn’t just a failure to repay; even though this is what is most commonly refers to. It is a failure to meet any legal obligation under the loan.
The consequences of default can be that the lender is no longer obliged to lend the money or if it has already been loaned, the lender can require immediate repayment of the total amount that was lent. If the loan is secured, the lender may enforce its security be taking possession of the asset providing security. If the default is also a breach of contract, such as if the borrower has misrepresented their financial situation, the lender may also claim losses against the borrower.