A business loan agreement is a legal contract between a lender and a business borrower that outlines the terms of a loan. It sets out a repayment plan, with interest and any other guidelines important to the financial arrangement.
Businesses often need loans to fund their endeavors and build their company. Lenders need to secure their interests in the money they lend to businesses. In either case, a business loan agreement template can help you build your own.
- What is a Business Loan Agreement?
- Minimum Requirements For a Business Loan
- Sections of a Business Loan Agreement
- Business Loan Agreement: Terms to Know
- How to Write a Business Loan Agreement
- Business Loan Agreement Sample
- Tips to Consider When Writing a Business Loan Agreement
- Disadvantages of Not Using a Business Loan Agreement
- Business Loan Agreement FAQs
What is a Business Loan Agreement?
A business loan agreement is a document that details the logistical, financial, and legal obligations of the parties to a loan agreement. The business borrower requests money and takes on debt to secure funds. It details a loan repayment schedule by which the borrower must repay the borrowed funds, including conditions for early payment or default payment.
Every business loan is different, but a template helps you get started on the document’s substance while allowing you to modify it to fit your needs.
When to Use a Business Loan Agreement?
You should use a business loan agreement whenever you lend money to a business. Even “small” loans to a friend’s business should be written down. Without this writing, significant disputes may arise over repayment. These disputes could end up in court and you may not be able to enforce your agreement if you do not have a written business loan.
You may want to use a business loan agreement for:
- Major asset purchases
- Business purchase agreements
- Borrowing from a bank
- Lending to a startup business
- Purchasing parts or products to build up an inventory
- Purchasing land or a building
Minimum Requirements For a Business Loan
If you want to take out a loan for your business, you must ensure you meet the minimum requirements. Most lenders will require you to fulfill certain criteria before they agree to give you a business loan. Some of the most important aspects lenders are going to consider when taking a look at your application include:
1. Credit Scores
If you want to take out a business loan, you must have a solid credit score. First, they are going to take a look at your personal credit score. Then, they might also look at your business credit score, if you have one.
Generally, credit scores range from 300 to 850. The higher your credit score is, the better the applicant you will be. There are plenty of ways you can improve your credit score. You should pay all of your bills on time, try to keep long lines of credit to lengthen your history and make sure you dispute any inaccuracies on your credit report as soon as possible.
2. Your Annual Revenue
Most lenders will require you to have some revenue stream before they provide you with a business loan. Every loan will have different minimums you must meet regarding annual revenue, so you must think carefully about which lender is best for you.
If you want to take out a business loan without a proven revenue stream, you will have to explore a non-traditional financing option.
3. The Years You Have Been in Business
The longer your history is, the better your chances of qualifying for a business loan. This means that the longer you have been in business, the more likely you will be approved for your business loan. Generally, lenders will require you to be in business for at least two years before they will provide you with a business loan, but online business loans might have some looser requirements.
4. The Strength of Your Business Proposal or Plan
Before the lender provides you with a loan, they want to know how you plan to repay the money. They also want to make sure you can pay it back. That is why your business plan and business proposal are so important. Your business plan will be responsible for explaining the goals of your business and how you plan to obtain them.
When you put together your business plan, you need to include documents demonstrating you have enough cash to cover the payments on your business loan. This is important for winning the lender’s confidence and maximizing your approval chances.
You will probably have to provide collateral to back the loan as well. Essentially, this is an asset that you have that can be seized by the lender if you go into default on your loan. There are different types of collateral, including property, inventory, and equipment. Collateral is a way for the lender to recover their money if your business fails. You might be able to find an unsecured business loan, but you will probably still have to provide a personal guarantee.
6. Financial Documentation
Finally, you will probably have to provide extensive documentation to qualify for a business loan. This might include your personal and business income tax returns, a profit and loss statement, a photo of your driver’s license, evidence of any commercial leases you have, your articles of incorporation, and bank statements. You may also want to consider providing your personal resume.
Sections of a Business Loan Agreement
As you look at a business loan agreement, it is important to ensure all sections are included. You may even want to use a business loan agreement template that can help you, but you must make sure that the most important sections are included.
Some of the most important sections that should be included in a business loan agreement include:
- Effective Date: This is the date the agreement takes effect. After this date has passed, the business loan agreement is binding for all parties involved.
- Parties, Relationship, and Loan Amount: This section includes basic demographic information about every party involved, including the borrower and the lender. It will also include your identifying information, address, and how the parties are related.
- Promissory Note or Mortgage: This section includes your promise to repay the loan.
- Collateral: This will specify the property or assets you use as collateral. This is what the lender will seize in the event you go into default on your loan.
- Terms and Conditions: This section will include the loan amount, the interest rate, and how long you have to pay back the loan. This section will also state whether you can pay the loan back early.
- Penalties for Nonpayment: This section will specify what happens if you miss a payment. For example, it may specify that you must pay a late fee or a grace period during which you can make a late payment without being penalized.
- Defaults and Acceleration Clause: This section will spell out fines and penalties if you cannot repay the loan and default. In addition, it could include an acceleration clause. The acceleration clause means that the entire loan balance might be due immediately if you do not meet the requirements the rest of the agreement sets forth.
- Jurisdiction and Governing Law: The law relating to business loans can vary from state to state. This section will specify which laws in which state are responsible for governing the agreement. It may also specify that a specific jurisdiction is to hear any disputes relating to the business loan agreement if there is a disagreement.
- Representations of the Borrower: When you take out a business loan, you must show that you have the legal right to engage in business in the state. This section will also specify that all financial information you have put forth in the agreement is correct and that you comply with all relevant tax laws in the jurisdiction.
- Covenants: When you enter into a loan agreement, you are making a promise to another party. This is called a covenant. The lender promises to disperse a certain amount of funds at a specific time, and you agree to pay them back in accordance with the terms of the agreement above. You might have to make other covenants as a part of the loan agreement. You might need to provide insurance for the collateral, get life insurance for the business owner, show that you are current on your taxes, and provide financial statements periodically. You might also be prohibited from taking on additional debt for some time.
Business Loan Agreement: Terms to Know
There are several other terms that you might come across as a part of the business loan agreement, they include:
- Amortization: It refers to how the loan repayment is divided into fixed payments over a certain amount of time. As soon as the loan goes into effect, you should be able to get an amortization calendar showing every scheduled payment for the duration of the loan.
- Annual percentage rate (APR): This is the interest rate attached to the loan. It is usually expressed as an annual rate.
- Automated clearing house (ACH) refers to how your loan payments will be made. Generally, it goes through an ACH system to automatically withdraw loan payments from your bank account.
- Balloon payment: If there is a large, single payment you will have to make at the end of the loan term, it is called a balloon payment.
- Blanket lien: A blanket lien allows the lender to seize just about any of the borrower’s assets to recoup any outstanding loan balance if the borrower cannot repay the loan.
- Co-signer: A cosigner is another party signing on behalf of the borrower who can improve the chances of the loan being approved. If the primary borrower cannot repay the loan, the cosigner could be held responsible.
- Curtailment: A curtailment refers to paying more money than is required monthly. A full curtailment means the borrower pays off the loan in full, early.
- Default: Default means that the borrower is not able to pay back the loan. If the borrower defaults, certain legal processes may kick in on behalf of the lender to recover the remaining loan balance from the borrower.
- Deferred payment loan: If the payments do not start immediately, it is called a deferred payment loan. The borrower and lender might agree that the payment process will start at a later date.
- Factor rate: This is a specific type of business financing expressed as a factor of the total loan amount instead of a traditional interest rate.
- Interest-only payment loan: Some loans only require interest to be paid on the loan instead of the principal. Then, when the loan term is up, the entire principal balance is repaid at once.
- Loan-to-value (LTV) ratio: It refers to the percentage of the asset’s value that is covered by the loan. This is usually found in real estate when a business needs a loan to purchase commercial property.
- Loan underwriting: This is the process the lender uses to decide the amount of risk that a potential borrower poses to the lender.
- Prepayment penalty: Some lenders will charge a penalty if the loan is paid off early. The lender will charge a penalty because they do not collect as much interest on the entire loan. A prepayment penalty is meant to compensate for the interest the lender loses on loan.
- Principal: The principle refers to the amount of the loan. It does not include the interest the borrower will pay on loan.
- Refinancing: During the refinancing process, a borrower will replace one loan with a different loan. Sometimes, borrowers want to refinance their loan because they might be able to get a different loan at a lower interest rate.
- Servicing: Servicing refers to how the loan is managed. This term covers how funds from the loan will be dispersed, how the payments will be collected on the loan, and what happens if the borrower does not make the payments on time.
Make sure you clarify any terms in the loan agreement you do not understand before you sign it.
How to Write a Business Loan Agreement
When you need a business loan agreement, you may feel nervous about starting one from scratch. With a simple business loan agreement, you can make one yourself and modify it to make any changes you need. Here’s some of the key information you should ensure is included in every business loan agreement:
Step 1 – Set an Effective Date
This is the date that money is provided to the borrower. This date is crucial, as it sets the repayment schedule which will follow. Typically, the effective date is the same date the document is signed. However, the contract loan agreement can choose a different effective date.
Step 2 – Identify the Parties
The two (or more) parties to the loan agreement should be identified in the agreement near the beginning. This should be information about both the lender and the borrower. Information should at a minimum include:
- The names of the parties, including business names
- Names of officers and signatories to the agreement
- Business and personal addresses as applicable
- Contact information, including a phone number and email
- Service of process information for business entities
- Any co-signer and their information
Step 3 – Include the Loan Amount
When you make or receive a loan, you should clearly identify the amount early in the document. The total amount will help determine how the payments are made in the future and how interest may affect the total loan. At the beginning, this is the principal amount of the loan, prior to the imposition of any interest.
Step 4 – Create a Repayment Schedule
The loan should include when repayment starts and the periods at which each payment must be made. This could be monthly, quarterly, yearly, or any other time period. Repayment may start right away on the loan, or at a later date.
A schedule, often an amortization schedule, is included or attached to the business loan contract to clearly identify the repayment timeline.
Step 5 – Define Security Interests or Collateral
Many loans will help secure repayment by using collateral. This is some type of personal property or secured interest in real property that may be collected upon in the case of a default. This is especially common in mortgage agreements but is common in many other kinds of agreements as well.
Step 6 – Set an Interest Rate
The interest rate is the amount the lender charges, in a percentage, of the principal for the loan amount. This amount is important and is often subject to significant dispute when it is not set down in writing.
Most types of loans require interest for repayment. It is how the lender makes money on the loan. Interest rates are often determined by the current market, the risk of giving the loan to this particular borrower, and many other factors. This section should also identify the type of interest rate, such as a fixed or variable interest rate.
Step 7 – Late Payment Fees
Nearly every loan agreement, especially for business entities, comes with penalties for late payment. This can cause late fees or charges, increases in interest rates, or other methods to deter late payments by the borrower.
Late payment, or continued nonpayment, may result in a default on the loan. A default should be fully considered in its own section of the loan agreement.
Step 8 – Determine Prepayment Options
The loan may or may not include a prepayment penalty. This creates a fee if the borrower pays off the loan ahead of schedule. Not every loan comes with prepayment penalties. It is up to the lender whether to include this provision or not. On the other hand, if the borrower pays all of the loan before a certain date, they could receive a discount.
Step 9 – Define Conditions of a Default
A borrower defaults on a loan when they fail to pay it back as required by the business loan agreement. It is crucial to define how a default will be determined. Some loan agreements state that one missed payment may result in a default. Others are much more forgiving.
A default can result in the acceleration of the loan if that provision is included. This means that default makes the entire amount due and owing right away. It also gives the lender a legal right of action against the borrower in most cases.
Step 10 – Have a Well-Defined Signature Section
The parties to the loan need to sign the agreement to be bound to it. Not only should the business officer sign on behalf of the business, but any personal guarantors or co-signers must also sign at this time. The signature lines should make clear whether the signatory is signing in their individual capacity or on behalf of the business.
Business Loan Agreement Sample
This sample of a business loan agreement can help you get started in drafting your own loan.
Tips to Consider When Writing a Business Loan Agreement
When writing a loan agreement, you should follow a few best practices that can help you create an easy-to-use and enforceable contract:
- Understand key terms: You need to know many terms in a business loan agreement. These may include “balloon payment,” “amortization,” “factor rate,” and much more. Know every term used in your contract to know what it means.
- Consider co-signers or guarantors: Many businesses, especially startups, are risky investments. A co-signer or guarantor agrees to pay the loan if the business cannot do so. Personal guarantees can help ensure you get paid for the loan you provided.
- Use appropriate attachments: Many business loans are complex documents. If you want to include additional documents to support the loan agreement, add them to the loan agreement and incorporate them by reference. This might include a purchase agreement or other business documents related to the transaction.
Disadvantages of Not Using a Business Loan Agreement
There are many disadvantages when you fail to use a business loan agreement. For lenders, these disadvantages include:
- Lack of enforceability for the loan
- Unclear repayment terms on which you can rely
- Decreased likelihood of timely repayment
- Inconsistent lending standards for customers
There are disadvantages for borrowers as well, including:
- Unclear expectations about what you owe and when
- Potential for high-cost litigation over the terms of the loan contract
- Possible abuse by a lender in forcing early repayment
- Possibility for higher interest rates or fees than originally agreed
Business Loan Agreement FAQs
Is a Business Loan Agreement Legally Binding?
Yes, a business loan agreement is a legally binding contract. When all of the appropriate information and signatures are included in the contract, the court will likely enforce the agreement. A well-drafted agreement can help you ensure that the agreement will be enforced.
What’s the Difference Between a Business Loan Agreement and a Promissory Note?
While they are similar, business loan agreements are usually more detailed and need the signature of both the borrower and the lender. Promissory notes spell out a promise to repay a loan but offer little other information relevant to the transaction.