Understanding Your Business Loan Agreement
You have been approved for a small business loan – congratulations! But do you understand it? Your business loan agreement contains all of the information on the contract formed between the business owner and the lender. While not always the easiest set of documents to understand, business owners who want to succeed must learn how to parse a loan’s terms and how they will affect their business.
Why is it Important to Understand your Loan’s Terms?
Why does it matter if you understand the legalese, as long as you get the money your business needs? Because you are signing legal documents which bind you, and your company, to specific terms and conditions. Everything in your loan documents will govern, and possibly limit, your business’ actions until the loan has been paid off in full.
Defaulting on any clause in your loan document could have serious repercussions. Moreover, “default” may not take the form that you assume, that of non-payment. While loan documents are not fascinating reading, they are also not something that a responsible business owner should skip. They contain clauses which legally bind both parties, which means that your lender could also violate a loan’s term.
Gaining a solid grasp on the terms of a loan and how business loans work will also guide better financial decisions. Knowing the difference between fixed and variable-rate interest will help you decide between two lenders. Making sense of your amortization schedule is crucial to cash flow management.
Understanding your loan’s terms, and the terminology used in lending helps make you an informed and savvy borrower. You can make better decisions to support your business’ growth and longevity. The better you manage your credit, the more credit you can access in the future. Handling debt well now ensures that you can borrow again when your business needs capital.
Terminology You Will Need to Know
Ignorance of the law is no excuse, and neither is ignorance of the terms in your business loan documents. Whether or not you understand them, if you sign for the loan, you are bound by them. For those unfamiliar with the banking world, particularly first-time borrowers, the terminology can be quite confusing. Before signing on the dotted line, make sure you know what these words mean and how they will impact you over the life of the loan.
Amortization – The term refers to paying off your loan by making regular payments over time. Your amortization schedule presents the amount of each payment that is applied to principal and the amount applied to interest. If you have a balloon loan, 100% of your payments will go to interest with the principal coming due in one lump sum at the end.
When you look at the amortization schedule of a fixed-rate, term loan, you will see that the percentage of each payment applied to principal gets gradually higher. As you pay down the principal, interest is charged on a lower principal balance each month. To hedge their risk, many lenders structure the amortization schedule to charge the most interest, and make the most profit, upfront.
If your loan has a straight-line amortization schedule, your payments will remain the same throughout its term. An easy example would be a $10,000 loan with $2,000 interest and a one-year term. Divide $12,000 by twelve months, and you will come up with your $1,000 a month payment.
Some online lenders subtract their interest payments from the loan funds that they disburse when it is funded. Under these terms, if you took out the $10,000 loan, you would only receive $8,000 into your bank account. This could be a big problem if you were counting on receiving all the funds, so it is essential to understand your loan’s amortization schedule because it tells you how the lender expects to be repaid.
Principal – The principal is the underlying sum borrowed or the remaining debt. It would be $10,000 in the previous example, but after a few months of payments, the principal balance would decline. Using rounded numbers, you would owe $7,500 by month three.
Annual Percentage Rate, or APR – When you search online for a small business loan, you will see many lenders touting their low interest rates. However beware because if they are quoting a simple interest rate what you end up paying for the loan could be much higher.
The Annual Percentage Rate, or APR, includes both the simple interest rate and all fees associated with your loan. While there is no way for it to include charges that the lender cannot predict, such as late fees, it is a more accurate representation of the loan’s total cost.
Co-Signer – It is not always possible for some business owners to obtain credit on their own merits. Their business may be too new, or they could have a lower credit score. A co-signer will be liable for the entire loan as well so all terms in the agreement should be clearly understood by any person who signs the agreement.
Curtailment – If you want to make a payment on principal in addition to your scheduled payments, it is called a curtailment. When reading your loan documents check, and see if there is a prepayment penalty. If so, there would be no value to you in paying off the loan early.
Interest-Only Payment Loan – Also called balloon payment loan, with an interest-only payment loan, all of your monthly payments are applied to interest. Your payments do not reduce the principal balance that you owe. An interest-only payment loan often has lower monthly payments than a loan where both principal and interest comprise each payment. It can be an excellent choice for a business owner who needs to fund a new venture but does not expect it to pay out for quite a while.
Balloon Payment – When your interest-only payment loan reaches the end of its term, the principal will come due in a large balloon payment. While a business owner can sometimes refinance an interest-only payment loan before it comes due, it is risky. To be on the safe side, do not take out this type of loan unless you are virtually certain you will have the entirety of the principal available for the balloon payment when its term ends.
Deferred Payment Loan – Would you like a grace period on your loan before you have to make payments? A deferred payment loan does not require that you start making payments until later in the loan’s life. It can give you a few months to a year of breathing room.
Keep in mind that this will impact your amortization schedule. If you borrow $50,000 over a three-year period but wait a year to begin paying on it, your monthly payments will be higher. For ease of example, just taking the principal you would pay $2,100 a month instead of $1,400 once you began making payments.
Again, this could have a significant impact on your business’s cashflows, so be sure that your cashflow forecasts support this type of loan.
Loan to Value or LTV Ratio – The term loan to value, or LTV, is more commonly used with mortgages or loans that are secured by collateral than by a business loan. Business owners who need equipment financing will need to become familiar with it, however.
The LTV is the ratio of the loan’s principal to the asset the loan covers. If your lender states that the LTV on a tractor loan cannot be more than 80%, that means that they will only fund a loan for 80% of its value. In other words, if you want to buy a tractor worth $25,000 you could solely finance $20,000 of it and would have to pay the remaining balance yourself.
This ratio tells borrowers how much cash they will need to put down on an asset to secure funding.
Factor Rate – This decimal shows the total repayment amount. It’s used for merchant cash advances and invoice financing and expressed as numbers such as 1.1 or 1.5. Multiply your loan’s principal by the factor rate to get to the loan’s interest. For example, if you borrow $10,000 for a year at a factor rate of 1.5, you’ll pay $15,000. The difference between the principal, $10,000, and that sum is the interest paid on the loan, or in the case of many alternative lending products like a merchant cash advance, the fee paid as it is not interest, but a straight cost and the true interest can only be determined based on how long the agreement is or how long it takes to pay back the entire amount. In this case, it would be $5,000.
Servicing – There is a cost to the lender to support your loan through its term. They must maintain customer service employees to help you with questions, process your payments and paperwork, and possibly follow up on late or missed payments. All of these actions fall under the umbrella of loan servicing, and your agreement could contain language regarding loan servicing fees.
Depending on the type of small business loan that you are taking out, you could see many of these terms in the documents. Learn their meaning before you are sitting at a closing or in a bank with a pile of papers to sign. Even a simple business loan can have many components to its agreement.
Components of an Agreement
Lenders, even brick and mortar banks, can now send all your loan documentation online. After signing in a few clicks, you will receive your money. As always, you should know what you are signing. A typical business loan agreement has several sections which contain information relevant to your loan.
Promissory Note – This document contains the core information about your loan. This includes the amount you agree to borrow, the loan’s term, i.e., the period over which you will pay it back, and your interest rate. It lays out how much you are borrowing, whom you are borrowing from, and who (the business owner) will repay the funds.
It will also have the loan’s effective date. The effective date is when the funds will be disbursed, which could be a different day than when you sign. The initial date, also likely to be in the promissory note, is when payments begin.
Sometimes the promissory note will contain the terms and conditions and sometimes they’ll appear in a different section. They often duplicate much of the information contained in the promissory note, such as the loan’s amount, term, and interest rate.
Security Agreement – If you have pledged collateral to secure your loan, you will have to sign this document. The security agreement will describe the assets used to secure the loan, whether it is a car’s VIN number or account numbers for your retirement accounts.
If you are asked to sign a security agreement, you could also be asked to sign a form called a UCC-1. This form allows the lender to place a lien against the assets you have pledged. This lien will become a matter of public record and could generate sales calls from other lenders. It would prevent you from disposing of those assets before paying off the lender and clearing the lien.
Interest Rate – Information on the interest rate could appear in your promissory note, but it is worth singling out. This rate is your cost of working capital. You will want it in writing, and you will also want in writing if it is fixed or variable to help determine the true APR.
A fixed-rate loan will probably just have a statement about the loan’s interest rate. A variable rate loan will contain language describing how and when your loan’s rate will reset. It will say something about “Prime plus 2.5%” or “LIBOR plus 1%.” While the language can sound confusing, what it means is simple. When the Prime borrowing rate or LIBOR resets, your loan’s rate plus a premium will shift with it.
If your loan starts with an interest rate of 5% which is LIBOR of 4% and the lenders 1% premium and LIBOR rises one point, you will then pay 6%. When planning your budget, be aware if your loan has a variable rate, as your payments could fluctuate.
Conditions – This document, or section of your promissory note, lays out “if, then” conditions that could apply. If your loan is in default for 90 days, then the lender can seize your assets. It explains what happens if you violate any of the loan’s covenants.
Items that Can Appear in the Fine Print
Most people view the fine print suspiciously as if it is a place where a lender hides unfavorable details. However, it represents additional clauses that may or may not apply to your loan. While you may see some of these clauses, you are unlikely to see all of them.
Personal guarantee – A personal guarantee gives a lender recourse to your personal assets should you default. If your business does not have enough assets or cash flow to secure the loan, the lender may request one. If you agree to a personal guarantee and default, they could seize your house, your car, or any investment and retirement accounts.
Note; even if you have structured your business as an LLC or corporation to protect your personal assets that will not matter if you sign a loan with a personal guarantee. The personal guarantee in your loan in effect voids the protection of your business’s structure.
Cross-default provision – This clause could be quite new if you only sought access to personal credit in the past. What this clause does it ensure that a lender can recoup their money immediately should you default on another loan with them, hence cross-default.
If you have multiple loans with the same lender, you represent a higher risk exposure for them. Therefore, if you show signs of distress on one loan, they do not want to wait until things worsen. They want to be able to collect as much of their principal as possible. Default on one loan, and find them all in default if you sign this clause.
Prepayment penalty – When a lender decides to give you money, it is because they can make a profit off the loan. The interest rate and/or fees represent that profit. Their profit must always be higher than safe investments, such as Treasury bonds, to justify their risk.
In most cases, when you pay off a loan early, the lender’s profit is reduced. This does not apply if they collected the interest upfront and deducted it from your initial capital disbursement. To protect their profit margins, many lenders will put a prepayment penalty in your loan agreement. It is important to note that small business loans from alternative lenders generally do not charge this penalty because of the way the contract is structured.
A prepayment penalty can be a lump sum or a percentage of the profit that the lender has now lost. If you hope to pay the loan off before its term ends you should avoid a loan with a lender that charges a prepayment penalty.
Late payment penalties – Even the best-laid plans can go awry. A major customer does not pay on time, or bad weather keeps customers home and sales dip, and you wind up paying late on your loan. While you should never accept a loan unless you are confident in your repayment ability, life happens.
Pay particular attention to the clause which addresses late payment penalties. In some instances, you could both pay a fee and see your interest rate rise if you pay late. With certain contracts or agreements if a confession of judgement (COJ) is signed any failure to pay can result in immediate action from the lender.
Definition of default – This spells out the conditions under which the lender will consider your loan to be in default. The lender decides which actions they will consider with a default, whether it is three late payments in a row, a negative account balance for too many days, or another triggering event.
A triggering event could have nothing to do with the current loan. Riskier borrowers are often asked to pledge that they will not take out another loan during the existing loan’s term. If you violate that clause, an utterly unrelated loan could go into default.
Pay attention to this clause, as you may assume that you would only be in default if you stopped paying altogether. That may not be the case, and you could find yourself in default without realizing it. The more risk you represent as a borrower, the more rigid the definition of default.
Restrictive Covenants – Large corporations are accustomed to finding restrictive clauses in their loan agreements. These clauses essentially ensure that the lender comes first, often by preventing other distributions of capital.
Restrictive covenants could prevent a corporation from paying out dividends to shareholders until they have paid off their loan or reduced it by a significant balance. They could also not allow share repurchases without the lender’s agreement. The lender wants any excess capital your business generates to go towards paying off its debt.
In a smaller business, the covenants could require you to carry insurance on the pledged assets. As well, the lender may specify that you must keep all taxes paid and licenses current. Typically, government debt takes precedence over private business loan lenders. The lender wants to make sure that you stay current on these obligations so that their claim on them is not superseded.
Financial Reporting Requirements – For higher value loans meant to fund a business expansion or enterprise through traditional financing, the lender could demand regular financial reporting. They could request an ongoing actual to plan budget, balance sheets, profit and loss statements, or more. The bank wants insight into your business while you are using their money, and to monitor your debt service ratios and cash flows.
The loan documents will lay out how and when you must submit these reports, and whether or not an accountant must audit them which could add additional costs to the overall cost of the business loan.
Representations of the Borrower – Representations of the borrower state that you have been honest with the lender and on your loan application. They reaffirm your representations to the lender, such as that you are the sole proprietor of your business. You may have to sign an affidavit that you have authorization to take out the loan on behalf of your business.
The legal terminology of “representations and warranties” is your promise that you complied with certain conditions before receiving financing. Commonly, one might see a condition that you have not taken on any new debt between the time you applied for the loan and when you are signing. The promises you make to the lender of what you will do during the loan’s term matter.
Red Flags when Signing a Business Loan Agreement
Everything covered thus far are fairly standard clauses in business loan agreements. Most are designed to protect the lender’s investment and hedge their risk. But are there any red flags that should give you pause?
Requests for Money Upfront – When a lender wants to receive their interest or fees upfront, they deduct it from the capital disbursed. They do not ask you to pay it out of your pocket. Every fee should have a valid business reason.
Changed Terms – One of the main reasons you should thoroughly read through your loan documents is to determine that nothing has changed from what was formerly agreed. If the interest rate or fee is higher than you expected, ask them why. The reason may be innocent, such as an increase in the Prime rate between the date you applied and the funding date, but it may not.
Unfortunately, there are unscrupulous lenders that count upon business owners not taking the time to read their documents. If anything looks different than what you expected, ask questions. Don’t be afraid to refuse to sign if the answers are unsatisfactory. Even consider an accountant or financial advisor take a look at your agreement before signing it.
Rushed Process – Does the lender, or loan officer, seem comfortable giving you time to read over everything in your loan agreement? Or are they rushing you through the signing? While they could simply have somewhere else to be, take note and pause to read everything.
Reputable lenders have nothing to hide and are willing to wait for you to read a loan agreement before signing.
Worries about Repayment – No one likes to put their personal assets on the line, but if you are anxious that you could lose them, maybe the business loan is not right for you. Before signing, crunch all the numbers and consider the worst-case scenario. Have a plan for how you will repay the loan. Ideally, the borrowed capital should also generate additional revenues for your company or are projected to do so. Plug all the numbers into your business plan. Do not borrow unless the rate of return on the investment is higher than the cost of capital.
Are any of the Clauses Negotiable?
It is best to negotiate the terms of your business loan before you get to the point of signing loan documents. However, should anything you negotiated appear differently in the loan documents be sure to raise the issue with your lender. Items which are typically negotiated include;
- Interest rate or Fee
- Repayment terms
- Co-signers, personal guarantees, or collateral
You might also be able to negotiate when loan payments will begin and a grace period. A business owner’s negotiation power does somewhat depend upon their credit. If you are seeking a bad credit business loan, you will have less bargaining power. However, do not be afraid to ask for items which would support your repayment.
Many alternative lenders offer flexible repayment plans that match your business’ cash flows. For example, you could repay your loan monthly, weekly, or daily. It can be automatically deducted based on the revenue your business generates so to compensate for slow business cycles. They should work with small business owners to find the best option for them.
What can happen if you Violate a Loan’s Terms?
It is worth emphasizing that the consequences for violating a loan’s terms can be severe. In the worst case scenario, you could go out of business.
Pledged assets can be seized, and if they are necessary to your business’s operations, it could impair your ability to keep operating. Your lender will report your default to the credit bureaus, and both your business and personal credit could take a hit. Many companies are also built upon reputation in the community, and defaulting on a loan to a local lender could have a ripple effect.
Taking out the wrong business loan, even if you do not default, can also hurt your business. Payments that are too high for you to meet, or that use up all of your free cash flow could restrict your business’ ability to grow. Before signing any loan agreement, have a clear idea of how you will repay the funds.
Simplified List of Items you Must Check before Signing
Signing loan documents can be a bit overwhelming. The legal terms and phrases are not presented in simple English. If you just want a quick checklist of what to look for when signing your loan agreement, here’s a high-level overview.
Understand the Terms and Conditions
At a bare minimum, you must comprehend how much you are borrowing, and when payments will be due, and what is the overall cost of the entire business loan once payback is complete. Make sure that the name on the loan appears correctly; either as yourself or as your business’ name depending upon who is borrowing. Also, have a clear idea of which actions would constitute default.
Check the Interest Rate or Fee
If you obtained a pre-approval letter or verbal confirmation of your interest rate or fee, check the business loan documents to see if they agree to the information previously provided. The rate might have reset or changed based upon Prime or other reasons, but it never hurts to check and ask questions.
Understand the Repayment Plan
There may be a grace period before you have to start making payments, or the lender could immediately begin taking a portion of every credit card sale or revenue generated. Whenever it is that you must start paying on the loan, circle that date in red on your calendar. Look at the amortization schedule or payment schedule, and plug the numbers into an online calendar, and put the payments into your budget.
The better you grasp how your business will repay the business loan, the lower your risk of default.
While it may seem like a burdensome task, taking the time to understand the legal documents you are signing can have long-term repercussions. Keep in mind that these documents also protect you from unscrupulous lenders, unexpected changes in terms, and loan conditions which could harm your business.