What Is a Loan Agreement?

Few people sail through life without borrowing. Almost everyone needs 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 brief papers 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 rates 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.

Purpose of a Loan Agreement

The 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 comply with state and federal regulations, which protect both lender and borrower should either side fail to honor it. 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.

Benefits of Loan Agreements

Borrowing money is a huge financial commitment, which is why a formal process is in place to produce positive results for 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. If it’s not clear it was a loan, it could become a taxable issue with the Internal Revenue Service.

Loan agreements are especially useful when borrowing from or loaning to a family member or friend. The agreement prevents arguments over terms and conditions.

A loan agreement protects both sides if the matter goes to 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 any time you borrow or lend money, a legal loan agreement should be part of the process.

When Can You Use a Loan Agreement?

Any time you borrow or lend money, it should be supported by a loan agreement. As mentioned, if the loan is from family or friends, it helps make the conditions clear and avoid arguments. If the loan is through a lender, business or individual you are not close to, that clarity is even more important. If the loan is to buy a home or vehicle, a written agreement ensures that the property on the line is protected.

A loan agreement can not only be used for any lending or credit situation, but it should also be.

If you are borrowing from a lender or getting credit from a business, a loan agreement is standard.

The most common types of loan agreements are:

• Debt consolidation: Used to combine multiple debts into one loan and one monthly payment.
• Personal loan: A loan from a bank, credit union, online lender, loan company or individual that’s for any purpose.
• Mortgage: Usually from a bank, credit union, online lender, or mortgage lender, provides money to pay for a home.
• Auto loan: From a bank, credit union, online lender, finance company or even the dealer, an auto loan pays for a vehicle.

What’s Included in a Loan Agreement?

While loans differ on specifics, depending on what they are for, the contents of all loan agreements have some general things in common. These include who the borrower is and their contact information, who the lender is, the specifics of the transaction (amount, term, interest rate, etc.), payback requirements and penalties for late or nonpayment and collateral requirements if they apply.

Some specifics of loan agreements are:

Interest Rate Determination

A loan’s interest rate depends on the type of loan, the borrower’s credit score and if the loan is secured or unsecured. A loan may also require collateral, which is a material asset that can be taken by the lender if the loan isn’t paid. State and federal laws regulate how high interest can be. Interest conditions, and whether it is fixed (remains the same amount) or floating (changes over time), will be spelled out in the loan. Floating fee rates are adjusted periodically and generally are only used in complex loans like adjustable-rate home mortgages.

Contract Length and Amortization

Once the lender and the borrower have determined the amount of money the loan is for, the lender will use an 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. The longer it takes to pay, the more expensive the mortgage is. For instance, if you borrowed $200,000, with 4% interest on a 30-year mortgage, you would pay $343,739 over the life of the mortgage.

Most mortgage loans allow early payoffs without penalty, and it’s a good idea to take advantage of that, or to pay more than required toward to the principal every month. The faster the loan debt is retired, the less money it costs.

Pre-Payment Fees and Penalties

Some loans come with pre-paid fees and penalties for paying off early. Prepayment penalties are typically found in automobile loans or in mortgage subprime loans. Refinancing a home or auto loan may also have pre-payment penalties. These are 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 five-year loan in three years, the lender loses the profit from interest that was expected the last two years of the loan.

Prepayment penalties usually are 2% of the amount due, 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 such loans. Government-backed FHA loans are protected by federal law from prepayment penalties unless the borrower has a mortgage that has a due-on-sale clause.

Breach or Default

If a borrower misses payments, or a loan contract is paid off late, the loan is considered in default. The borrower can be liable for potential legal damages to compensate the lender for 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

Mandatory arbitration requires the borrower and lender 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.

Mandatory arbitration tends to favor lenders, who have legal counsel that specialize in the process. The borrower often has no, or inadequate representation, because lawyers are not guaranteed payment in arbitration cases.

There is no appeal after an arbitration decision, and the Fair Credit Reporting Act and the Truth in Lending Act have no bearing, also putting borrowers at a disadvantage.

Military personnel serving overseas are especially vulnerable to mandatory arbitration in loan agreements. They may not be able to attend or have representation at an arbitrary hearing back home, meaning they could lose their vehicle.

If a loan agreement includes a mandatory arbitration clause, decide before signing it whether you are comfortable with that as a means of settling disputes.

Usury and Predatory Protections

Federal and state consumer protection laws guard against predatory and usury loan tactics used by lenders. The Truth in Lending Act, Real Estate Settlement Act and the Homeowners 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.

Legal Terms to Consider for Loan Contracts

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 also standard legal terms involved in loan agreements, regardless of whether the contract is between family and friends or between lending institutions and customers.

Four key terms to know before signing a loan agreement:

• Choice of Law: This refers to the difference between laws in jurisdictions. If the laws in states connected to a loan are different from each other, it must be determined which jurisdiction’s laws will apply.
• Involved Parties: These are the borrower and lender, and information about them in the loan agreement should include names, addresses, Social Security numbers (for individuals) and phone numbers.
• Severability Clause: This states that the terms of a contract are independent of each other. If one is deemed unenforceable by a court, that doesn’t mean others are.
• Entire Agreement Clause: This lays out what the final agreement will be and supersedes any agreements previously made in negotiations.

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 notice is given. The notification requirement is usually spelled out in the loan agreement. Demand loans with friends and family members might be a written agreement, but it might not be legally enforceable. Bank demand loans are legally enforceable. Overdraft protection is one example of a bank demand loan – if you don’t have the money in your account to cover a check or automatic withdrawal, the bank will pay it. It’s a small loan that you are expected to repay quickly, usually with a penalty fee.

Fixed term loans are commonly used for large purchases and lenders often demand that the item bought, most commonly a house or car, serves 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 a maturity date for 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.

How to Write a Loan Contract

The internet age makes it easy to write your own loan contract. Many software companies, including Adobe, Microsoft, and Google, as well as online legal information pages, provide templates for loan contracts that are available to download for free.

By its nature, a contract is agreed to and signed by both parties, so both borrower and lender must review it carefully and agree to all of the terms before signing.

A template provides all the relevant loan agreement terms, but as long as you include the necessary contents of a loan agreement, even if you’re starting with a blank piece of paper, it will be binding.

The steps for writing a legally binding loan contract are:

1. The effective date of the loan.
2. What state’s lending laws will apply (if lender and borrower are in different states).
3. Full information on both the borrower and lender. This includes their full legal names, Social Security numbers, telephone number and address.
4. Loan amount. This is the principal of the loan and does not include interest or fees.
5. Interest amount. If there is interest applied, the percentage amount, and how often it will accrue must be specified. How interest is charged affects repayment amount, so the numbers should be considered carefully and understood by both parties.
6. Repayment. Will it be a single payment with a specific payment date, or on demand? Are payments monthly or at some other regular interval? If so, what is the payment amount?
7. Late fees. If fees will be charged for late payments, the amount must be specified, as well as how late the payment must be before they are applied.
8. Collateral (if applicable). If the loan is going to be secured by property, that must be specified in the loan agreement. The details should be as specific as possible.
9. Prepayment or early payment. Specify whether the loan can be paid in full early, or whether there will be penalties for doing so.
10. Default. Both parties must agree to how many payments must be missed before the loan is in default, and what happens once it is.
11. Co-signer (if applicable). The lender may require a cosigner (legally, a guarantor) to ensure that the loan is paid back. If the borrower defaults, the cosigner must pay the balance owed. The co-signer will sign the loan along with the borrower and should also review the contract before signing. A loan agreement may include a box to check on whether there is a co-signer, or if there is not one, but it’s not necessary.

Loan Agreement Options

Most online templates include options that may or may not apply to your loan and that you can use, or disregard.

One option you should include is that the lender has the legal right to enforce the terms of the contract.

Other language isn’t as necessary, or may not apply, but things both borrower and lender should consider are:

• What circumstances, if any, would allow the agreement to be altered?
• Who pays legal costs if the agreement ends up in court?
• Can the loan be transferred to another borrower or lender?
• How will disputes be solved? Mediation, arbitration, court, or some other remedy?
• Will it be signed by a notary? (This is not necessary600 but usually suggested if the loan is for a large amount. It helps support the legality of the agreement in court.)

Loan Agreements vs. Promissory Notes

Promissory notes resemble loan agreements but are less complicated. Often, they are little more than commitment-to-pay letters, such as IOUs or simple payment on demand notes. The borrower or lender writes a letter specifying how much money is being borrowed or lent, and the terms for repayment.

They may be secured with collateral, have interest and installment payments and more, just like a loan agreement, but they are not. Loan agreements are more complex, with specific language, and are official legal documents.

When to Use a Promissory Note

Use a promissory note if some or all of this applies:

• The loan is for a small amount.
• When the borrower and lender are family or close friends.
• When both parties want a simple record to document the fact the loan was made.
• When the lender is flexible about repayment terms.
• When a lender doesn’t plan to take legal action if the loan isn’t repaid.

Use a loan contract if some or all of this applies:

• The loan is for a larger amount.
• It is not between family or close friends.
• The borrower has shaky finances or poor credit.
• The lender is not flexible about repayment or terms and is relying on getting the money back when and how it was agreed to.
• Either party wants a binding legal document that officially lays out all the terms of the loan, including repayment, penalties, interest and more.