A loan agreement is a legal contract between a borrower and a lender. It establishes how much money is being borrowed and sets other terms of the loan, including the repayment schedule and interest, if applicable.
You should use loan agreements any time you lend or borrow money, with or without interest. This includes:
- Lending or borrowing money within your family
- Lending or borrowing money among your friends
- Borrowing money from an institution to finance a home, car, or university tuition
What Is a Loan Agreement?
A loan agreement is a written contract between two parties — a lender and a borrower — that can be enforced in court if one party does not hold up their end of the bargain.
The borrower agrees that the borrowed money will be repaid to the lender at a future date, often including interest. In exchange, the lender can’t change their mind and decide not to lend them money, especially if the borrower relies on the lender’s promise and makes a purchase expecting that they’ll receive the loan.
A loan agreement is sometimes called:
- Business loan agreement
- Loan contract
- Personal loan
- Promise to pay
- Secured/unsecured note
- Term loan
What’s the Difference Between a Loan Agreement, Promissory Note, and IOU?
A loan agreement is generally more formal and less flexible than a promissory note or IOU. This agreement is typically used for more complex payment arrangements and often gives the lender and borrower more protections such as borrower representations, warranties, and covenants.
In a loan agreement, a lender can usually also accelerate the loan if the borrower defaults. So if the borrower misses a payment or goes bankrupt, the lender can make the entire amount of the loan plus any interest due and payable immediately.
Here is a simple chart explaining the difference between an IOU, a promissory note, and a loan agreement.
|promise to repay||promise to repay||promise to repay|
|steps for repayment||steps for repayment|
|timeline to repay||timeline to repay|
|legally binding||legally binding|
|signature of borrower||signature of borrower|
|signature of lender|
|repay in installments|
|consequences of defaulting (i.e. right to foreclosure)|
You can view our article on the differences between the three most common loan forms for more detailed information.
How Will the Money Be Repaid?
The loan agreement should detail how the borrower will pay the money back and what happens if the borrower cannot repay.
There are generally four types of repayment options:
|Installments with Final|
|Due on Specific Date|
|Due on Demand
(“Payable on Demand”)
|Specific due date||Specific due date||Specific due date||No specific due date|
|Payments for principal and interest are made at regular intervals||Payments for interest only are made at regular intervals, principal amount due on maturity date||Entire amount owed, including interest, is paid all at once||Entire amount owed is due whenever the lender wants his or her money back|
|Example: $1,500 monthly payment actually consists of $500 towards the outstanding principal and $1,000 towards the interest with $1,500 due on the maturity date||Example: $500 monthly payment is applied only towards interest and full $10,000 loan amount is due on the maturity date||Example: $10,000 loan for a friend’s small business is due on a specific date||Example: $10,000 loan for a friend's small business is due at any time or whenever financially feasible|
Types of Loan Agreements
There are many different types of loan agreements, including:
If you co-sign a loan for someone else, such as your spouse or child, you’ll be equally responsible for repaying the loan. The lender can approach you for repayment if they cannot collect a payment from the borrower.
A fixed-rate or term loan has an interest rate that stays the same for the entirety of the loan’s term. Your lender sets the interest rate when issuing your fixed-rate loan. For example, a 30-year fixed-rate mortgage at 4% maintains the same interest rate for the whole 30-year period.
Secured loans are personal or business loans that require collateral as a precondition for borrowing, typically a home or vehicle. If you stop making payments on the loan, the lender can seize the property you used to secure the loan. For example, the bank can start a foreclosure proceeding in a mortgage loan by auctioning off your home and using the proceeds to repay the remaining amount.
Common examples of secured loans include:
- Life insurance loans
- Vehicle loans
- Secured credit cards
- Car title loans
- Bad credit loans
In contrast to secured loans, unsecured loans don’t require collateral and are only backed by a contract. This kind of agreement results in less paperwork and faster approvals. However, it may be difficult to obtain an unsecured loan if you don’t have a good credit score. You may also have to pay a higher interest rate for unsecured loans.
One of the most popular types of unsecured contracts is a signature loan. Also known as a character loan or good faith loan, a signature loan requires only your signature and a promise to pay. Other examples of unsecured loans include most credit cards and student loans.
Variable-rate loans have interest rates that change over time. However, their rates may be fixed for a few years at the beginning of the loan.
The underlying index or interest rate for variable rates depends on what security or loan you have, but it’s most commonly based on the federal funds rate or the London Interbank Offered Rate.
2. Who Needs a Loan Agreement?
While loans can occur between family members – called a family loan agreement – this form can also be used between two organizations or entities conducting a business relationship.
Here is a table detailing common borrowers and lenders who might need this agreement:
|Possible Lender||Possible Borrower|
|Seller of a home||Buyer of a home|
|Seller of a car||Buyer of a car|
|Family member||Family member|
|Sympathetic friend with extra funds (i.e. able to lend but not give money)||Reliable friend with unexpected debt (i.e. unforeseen medical bills)|
When To Use a Loan Agreement
You should use a written loan agreement whenever you lend or borrow money.
Relying only on a verbal promise is often a recipe for one person getting the short end of the stick. If the payback terms are complicated, a written agreement allows both parties to clearly spell out any installment payment terms and the exact amount of interest owed.
If one party does not fulfill their side of the bargain, having this agreement in writing has the added benefit of recording both parties’ understanding of the consequences involved.
If a disagreement arises later, a loan agreement serves as evidence to a neutral third party like a judge who can help enforce the contract.
Here are some situations where you may need a loan agreement:
- Starting a business with a capital loan
- Purchasing land or a home with a real estate loan
- Investing in a college education or repaying a student loan
- Buying a new car or boat
- Getting a paycheck advance from an employer
- Helping a friend or family member out with a personal loan
When making a loan agreement contract between family members, you should be aware that there can be tax implications. For example, if you lend money without interest then the IRS may charge you tax because it would be below the minimum interest rate required for family loans. This is commonly known as the Applicable Federal Rate (AFR).
Also, if you’re borrowing money from family or friends and you aren’t expected to pay the loan back, the IRS will consider the loan as a gift and charge you income tax.
Loan agreements can also help you determine which lenders to avoid. People or institutions who lend money at high interest rates may be loan sharks. Loan sharks use predatory loan tactics to charge high rates, leading to a vicious debt cycle.
What Happens If I Don’t Have a Loan Agreement?
A simple loan agreement details how much was borrowed, as well as whether interest is due and what should happen if the money is not repaid.
Here is a chart of some of the preventable suffering a loan agreement could prevent:
|Borrowed money unpaid||Unpaid bills|
|Loss in value of used house or car||Paid for a house or car with no proof|
|Pay the IRS a gift tax of up to 40%||Pay the IRS income tax on the “gift”|
|Expensive lawyer fees to:||Expensive lawyer fees to:|
|Loss of friendship or family trust||Loss of friendship or family trust|
|Personal safety & well being||Personal safety & well being|
How To Write a Loan Agreement
Here’s a step-by-step on how you can write a simple Loan Agreement with a free Loan Agreement template.
Step 1 – Name the Parties
A Loan Agreement should detail the name of the lender and borrower. It should include their legal name, not informal designations or “nicknames.” This legally identifies the parties involved in the loan, so a proper legal designation of the parties is essential. The initial section of your agreement should look like this:
Step 2 – Write Down the Loan Amount
Provide the amount you will be loaning the borrower. This amount is referred to as the ‘principal sum’. It does not take into account the total amount including interest.
Step 3 – Specify Repayment Details
This section is where you will have to provide the details of the borrower’s loan repayment. The options you choose will have to be mutually agreed upon. You can choose whether the loan will be repaid in regular payments or all at one time.
Regular Payments: The borrower repays the lender in a set number of payments over a set period of time as specified in the document.
Single Payment: The borrower repays the lender all at one time by the date that is specified by the lender OR “on demand” by the lender. With a “Due on Demand” payment option, the borrower repays the entire loan upon the demand of the lender.
If you choose regular payments, you have to specify the repayment schedule, which can be monthly, quarterly, semi-annual or annual installments.
Step 4 – Choose How the Loan Will Be Secured (Optional)
If you would like the loan to be secured, you can include what property the borrower has put up for collateral here. Make sure you are specific, providing as many relevant details as possible. This property also has to be mutually agreed upon by both parties for it to be legally valid in court.
Step 5 – Provide a Guarantor (Optional)
A cosigner or guarantor is optional and protects the lender in case the borrower defaults on the Loan Agreement. You may require a cosigner if the borrower is in questionable financial standing. The cosigner is someone who jointly signs the agreement with the borrower.
In case the borrower defaults and cannot pay back the amount in full, the cosigner is responsible for paying you back the amount due. The cosigner is usually someone in good financial standing or has excellent credit.
Step 6 – Specify an Interest Rate
You should include the interest rate you will be charging the borrower in a percentage. This interest rate will be applied to the principal amount of the loan, and it is important that this rate is agreed upon by the borrower.
Step 7 – Include Late Fees (Optional)
As a lender, you have the option to charge late fees if the borrower does not meet a payment in time. Including a late fee can be a motivator for the borrower to make their payments on the agreed dates.
Step 8 – Determine Options for Prepayment
You can include whether penalties or discounts will be applied if the borrower decides to pay the loan amount ahead of schedule. Alternatively, you can explicitly state that prepayment of the loan is not allowed in the agreement.
A penalty is usually applied to deter the borrower from paying the loan back early and to encourage long-term payments. The loan would then accrue more interest, which can be a favorable arrangement if you’re the lender.
Step 9 – Include Provisions for a Default
When the borrower is unable to pay back the loan as detailed in the loan agreement, the borrower has entered into default. You should clarify how the borrower will default in the document. Loan agreements can say missing one payment causes a default, but as a lender, you can be more lenient with the terms.
Defaulting on a loan can give you the legal right to accelerate payment. In this scenario, you can make the full amount of the loan due immediately.
Step 10 – Add in Relevant Terms
Further terms make up the remainder of the loan agreement and serve to protect the rights of both parties and they include provisions such as:
- The legal right for the lender to enforce the terms of the agreement
- The costs and expenses associated with taking the case to court
- The transferability of the loan agreement
- The capability of alterations to the agreement
Step 11 – Specify How You Would Like To Communicate
You can establish communication methods for yourself and the borrower so both parties are on the same page. This avoids either party claiming that they didn’t receive a notice.
Step 12 – Include Your Resident State
Clearly indicate your resident state in the loan agreement so both parties are aware of which state or jurisdiction laws they have to follow.
Step 13 – Determine How Disputes Will Be Resolved
Detail the procedure for how both parties can resolve any disagreements. There are numerous options available, ranging from court litigation to mediation. Keep in mind that pursuing court litigation will mean the party who lost the court case will have to pay the other party any costs and fees related to the court process.
Step 14 – Include All Relevant Signatures
The parties involved in the loan agreement should sign the agreement. This includes any personal guarantors or co-signers.
What Should Be Included in a Loan Agreement?
You should always include the following in your loan agreement:
- Borrower: (aka the “buyer” or “payer”) who is receiving the loan from the lender and is responsible for repaying the debt
- Lender: (aka the “issuer”, “maker”, “payee”, or “seller”) who is giving the borrower money and receive the repayment
- Principal amount: the sum of money being borrowed
- Interest: additional money owed, usually a percentage, based on the amount borrowed and time until repayment
- Maturity date: when the money should be repaid
The contract may also include these provisions:
Acceleration: whether the lender can move up the date of repayment or make the borrower repay the loan immediately. Possible events of acceleration include:
- If the borrower becomes bankrupt
- If the borrower fails to make payments
- If the borrower passes away or the company dissolves
- If the borrower wants to pay off the note early
- If the borrower sells off a large or material portion of their assets
- Amendment: any changes to the agreement, which must be in writing
- Collateral: what property the lender can keep if the borrower defaults
- Governing law: which state laws apply if there is a problem with the agreement
- Joint and several liability: states that all of the borrowers are individually responsible for the full amount of the loan
- Late charges: states that the borrower pays a penalty if payment is late
- Prepayment: allows the borrower to pay off the loan and interest early, possibly for a discount
- Right to transfer: allows the lender to transfer the loan to another party
Loan Agreement Sample
Our loan agreement template addresses the following details:
- Who: the borrower and the lender, or the person taking money and the person giving money
- What: the amount of money — or principal — that is being borrowed, and whether interest or a percentage of the principal is also owed
- When: the date or timetable that the principal and any interest should be paid back to the lender
Loan Agreement Frequently Asked Questions
It’s not necessary to notarize a personal loan agreement. However, you may want to notarize the document if it involves a large sum. Notarization will help prove the document’s validity if it’s challenged in court.
Yes, a personal loan agreement is legally binding. Whether the lender is a financial institution or an individual, the court will uphold the terms of the loan as long as both parties sign the agreement.
If you are the borrower, it is crucial to make sure you can repay the loan, as the lender will have the right to sue you in court for the amount owed. If you cannot pay the lender back, you will have to provide other means of compensation, such as giving up some of your assets or having your wages garnished.
Yes, in certain instances, you can cancel a loan agreement. There should be a section on termination in the document’s terms and conditions. It should provide you with everything you need to know about how you can get out of the contract.