A loan agreement serves as a binding contract between a borrower and a lender. It legally formalizes the loan and indicates some essential conditions on the contract.
Whether you’re the borrower or lender, it is important to look out for certain key terms before acquiring for making a loan available, because these terms indicate the most important elements of the contract and dictate how and when the loan should be repaid.
In this article, we will discuss the most important terms to include or look out for in a loan agreement.
Key Terms in a Loan Agreement
The most important terms you need to look out for in a loan agreement include:
- Interest
- Prepayment
- Default interest
- On-demand or Fixed (Repayment plan)
- Events of default
- Committed or Uncommitted Loans
- Bilateral or Syndicated Loans
- Secured or Unsecured loans
Interest
Most often, lenders attach an interest to their loan amount to compensate for the risk they’re undertaking. This interest reflects the percentage of the original loan the borrower must pay in addition to the loan principal. For example, if the interest rate is 5% on a loan of $100,000, the borrower will be expected to pay back $105,000. There are two main types of interests: simple (or non-compound) interest and compound interest. The difference between the two is primarily the way the interest accumulates.
Compound interest increases and is added to the accumulated interest of previous periods, so borrowers must pay interest on interest as well as principal, while simple interest is a fixed percentage of the principal amount that was borrowed or lent. Typically, simple interest is used only for loans and investments of less than one year.
Prepayment
A loan agreement usually includes plans for early repayment. Prepayments function differently from installmental payments. While installmental payments only includes a weekly, monthly, or quarterly payment, prepayments involve paying back the full borrowed fund at an earlier-than-agreed date. Prepayment is a payment made in advance before the debt is officially due.
Default Interest
There is the possibility that a borrower may not be able to repay the loan at the agreed date. This is exactly why a default interest needs to be included in the loan agreement. The default interest is an extra interest on the loans that protect a lender whenever a borrower is unable to repay their loan at the due date or if the loaned amount has not been fully paid in the case of installmental payments.
Default interest is also triggered by other instrumental events, like bankruptcy of the borrower, filing of legal claims against the borrower, failure to meet non-financial covenants of borrower towards lender, or other events of defaults, as described below.
On-demand or Fixed (Repayment)
Both standard and basic loan agreements include how the repayments will be made. Sometimes, lenders reserve and exhibit the exclusive rights to demand repayment for their loans. Lenders can also fix a date for repayment. Fixed repayment plans require that both borrower and lender agree to a date for repayment.
Events of Default
An events of default is usually applicable on loans with fixed repayment dates. The events of default clause pulls the borrower into default.
There are 4 major events of default you should look out for. These include:
- Cross default
- Insolvency
- Breach of loan agreement
- Specific breach in form of non-repayment
Committed or Uncommitted
A committed loan agreement contractually obliges the lender to lend a loan amount to a borrower once they have satisfied some dictated Conditions Precedents (CPs).
These Condition Precedents are usually established at the start of the loan agreement. In an uncommitted loan agreement, the lender is not obliged to lend the borrower money after CPs are met. As such, there is mostly no need for CPs.
Bilateral or Syndicated
A bilateral loan is provided by one lender while a syndicated loan is provided by two or more lenders. If you are a borrower, and unless you are dealing with Investment Banks and other corporate establishments, your loan would be most likely bilateral. It always helps to be sure though.
Secured or Unsecured
A loan secured against an asset is called a secured loan while an unsecured loan is not secured against an asset.
Regardless of the kind of loan being given or procured, a loan agreement is an important part of the procedure that ensures the interest of both parties are protected. It should therefore be taken seriously, carefully written and assessed to contain all the key terms necessary, in order to prevent the stress of avoidable misunderstandings and disagreements over unclear terms in the future.
