Synopsis: Understanding the key terms in a business loan agreement is crucial for confidently dealing with the borrowing process and avoiding unwelcoming surprises. This quick guide will easily familiarize you with the most commonly used key terms in a typical business loan agreement copy.

A business loan agreement is a legally enforceable contract that delineates the terms and conditions of a loan between a business and a lender.These might seem basic but  are essential details that often get overlooked in the excitement of securing funding. It’s like a rulebook for the loan to ensure both parties are on the same page. This agreement covers essential aspects like loan amount, repayment schedule, interest rates, covenants, defaults, representations, etc. Understanding these terms before signing is vital. In this regard, let’s have a clear understanding of the key essential terms involved in a typical loan agreement copy.

Core Loan Terms To Understand

1.    Loan

A loan is a financial tool that provides your business with funds from a lender such as a bank or a financial institution. These funds are borrowed with the agreement to repay them with interest over a defined period.

2.    APR

In business loans, APR (Annual Percentage Rate) is the yearly cost of borrowing that is expressed as a percentage. It factors in the interest rate and additional fees like origination charges. Understanding APR is important as it allows you to easily compare loan options from different lenders because it presents the total yearly cost in a standardised format.

3.    Prepayment penalty

A prepayment penalty is a fee assessed by a lender if you pay off your business loan early. It compensates the lender for the lost interest income they would have earned if you followed the full loan term. The prepayment penalty can be a flat fee or a percentage of the remaining loan amount. Ideally, financial institutions mention the penalty amount and timeframe for application in the loan agreement.

4.    Interest rate

Interest rate is the fee you pay to borrow money for your business loan. However, did you know there are two different types of business loans? Yes, the business loan interest can be one of the following two categories:

• Fixed interest rate: This rate stays the same throughout the entire loan term. A fixed interest rate makes budgeting easier as it offers predictability in your monthly payments. However, you might miss out if interest rates go down overall.
• Floating interest rate: This rate fluctuates based on a benchmark index (like Prime Rate). It can be beneficial if interest rates are expected to decline, but it also introduces uncertainty in your monthly payments.

5.    Loan Guarantor

A loan guarantor is an individual who personally guarantees the repayment of the loan if the business itself defaults. The guarantor is typically someone with strong financial standing, like a business owner or a partner. If your business does not meet its loan repayment obligations, the lender can hold the guarantor personally liable for the outstanding debt. Therefore, the presence of a strong guarantor can increase the chances of getting a business loan for startups or businesses with limited credit history.

6.    Amortisation

Amortisation is gradually paying off the loan over time through fixed payments. Each payment is divided into two parts:

• Interest: covers the cost of borrowing the money
• Principal: goes towards reducing the actual amount you borrowed

With each payment, your loan balance steadily shrinks while giving you a clear picture of future loan payments for easier financial planning.

7.    Balloon payments

A balloon payment refers to a large, singular sum due at the end of the loan term instead of being spread out in smaller payments throughout. These loans typically have lower regular payments compared to fully amortized loans. Your payments may only cover interest or a portion of the interest and principal. This is helpful for high-net-worth borrowers with adequate capital who can pay a large sum of money at the maturity date.

8.    Default

Default refers to a situation where your business fails to meet its loan repayment obligations as outlined in the agreement. Typically, default occurs after missing a certain number of consecutive loan payments or if you violate other terms of the loan agreement. If a default situation occurs, the lender may impose late fees and even accelerate the loan balance through debt collection agencies.

9.    Covenants

Covenants act like guardrails to ensure the interests of both the borrower and the lender are protected throughout the loan term. Covenants can be categorized into two main parts:

• Financial covenants:
• Focus on the borrower’s financial health and performance
• Examples include maintaining a minimum level of cash flow, debt-to-equity ratio, or profitability.
• Non-financial covenants:
• Restrict certain actions the borrower can take
• Such as limitations on taking on additional debt, making large dividend payments to shareholders, or selling major assets

Fulfilling covenants can make your business more attractive to lenders and unlock access to better loan terms.

10.Representation

Representations are statements made by the borrower about what the lenders take into account when deciding to approve the loan. These are assurance statements about the borrower’s current business health and situation. This can include the borrower’s business income, profitability, debt levels, and asset valuations. That said, if a representation turns out to be untrue, it can be considered a breach of the loan agreement.

11.Promissory Note

It is a legal document that formalizes the loan agreement between a borrower and a lender. This is a legally binding contract that protects both the borrower and the lender in case of a dispute.

A promissory note clearly identifies:

• Parties involved
• Loan amount
• Interest rate (if applicable)
• Repayment terms
• Maturity date
• Signatures from authorized representatives from both sides

Promissory notes are commonly used for unsecured loans where a simpler, standalone document is preferred to outline the repayment terms.

12.Effective Date

An effective date refers to the specific date on which the loan agreement becomes legally binding and enforceable for both the borrower and the lender. It marks the official start of the loan term. Once the effective date arrives, both parties have legal obligations to fulfill as outlined in the loan agreement. 

13.Acceleration Clause

An acceleration clause, also sometimes referred to as an acceleration covenant, is a provision included in most business loan agreements. It outlines specific events or actions that could trigger the lender to demand full repayments of the remaining loan balance immediately instead of following the original repayment schedule.

14.Factor Rate

A factor rate is a decimal number that represents the total cost of repaying the loan, including both the principal and the interest. To calculate the total repayment amount, you multiply the factor rate by the original loan amount you borrowed. For instance, if you receive a loan of Rs 10,000 with a factor rate of 1.20, you’ll need to repay the lender Rs 12,000, including a total cost of borrowing of Rs 2,000. 

15.Loan underwriting

Loan underwriting is the process a lender uses to assess your business’s creditworthiness and determine the risk involved in lending you money. It’s essentially an evaluation to check whether you’re a good fit for the loan and how likely you are to repay it successfully.

16.Cosigner

In a business loan, a cosigner acts as a safety net for the lender. They are essential individuals who guarantee to repay the loan if your business fails to meet its repayment obligations. Young businesses or those with limited credit history might benefit from a cosigner to strengthen their loan application.

While a cosigner and a loan guarantor both agree to take responsibility for a loan if the primary borrower cannot make payments, their obligations differ. A cosigner is immediately responsible for the debt, stepping in if any payment is missed.

In contrast, a guarantor’s responsibility is activated only if the borrower defaults on the loan, which generally means missing several payments over a period of time. This distinction is crucial for both the lender and the individuals who agree to support the borrower, as it affects when and how they might be called upon to fulfill the obligation.

Conclusion

Understanding the key terms of your business loan agreement can help you avoid surprises and ensure a smooth borrowing experience. With all details clear in mind, you can focus on using the loan to propel your business forward. In this regard, partnering with a digital loan provider can offer transparent terms that are accessible at your fingertips, saving you valuable time and effort.