Cash 1 Blog
What Is a Loan Agreement? - Everything You Should Know
It's common to click the I agree to the terms and conditions box without reading it, but it's essential to read your loan documents carefully. Unlike other service contracts or technology privacy policies, your loan agreement is packed with requirements and details you need to understand. Whether a borrower or a lender, you must be meticulous regarding your loan agreement. Ignoring the details could lead to a default of your loan. If you're considering a loan, read about loan agreements and what makes them indispensable.
What is a Loan Agreement?
A loan agreement is a legally bound contract between the lender and the borrower, which formalizes the terms of your loan.
The essential function of a loan agreement is to outline the terms and conditions both parties have agreed to, which include various terms such as the interest rate, the loan principal, the loan repayment method, and the loan term length.
A loan agreement can range from simple documents that outline the loan principal and the rate of interest to more complex and elaborate documents like mortgage agreements, depending on the borrowed amount of money and the purpose of the loan.
Why is a Loan Agreement Important?
For many reasons, legally bound loan agreements are essential for borrowers and lenders. Some of them are:
- It safeguards the interests of both the borrower and the lender in circumstances where one party might fail to honor the loan agreement. It helps to significantly reduce the chances of disputes about the terms and conditions of the loan.
- A loan agreement aids a lender by legally enforcing the borrower's promise to repay the loan amount owed to the lender. The agreement allows the lender to seek legal assistance if the borrower fails to repay the loan amount.
- Borrowers also benefit from loan agreements. The agreement contains a record of loan details such as the interest rate, the total, and the loan term length. This ensures transparency between both parties involved, and the borrower can keep track of the monthly loan payments.
- Without a loan agreement, the lender can tweak any verbal terms and conditions in their favor. This can land the borrower in trouble as they would not have any proof to dispute the lender.
- A loan agreement also protects the borrower from the IRS. The agreement proves that the borrower's money is a loan, not a gift amount, and cannot be taxed.
Types of Loan Agreements
There are essentially two kinds of loan agreements:
A loan that needs to be borrowed against collateral or security is called a secured loan. If the borrower defaults on the loan repayment, the lender can use the collateral to compensate for the loss. Houses, jewelry, and cars are some common examples of loan collateral. Secured loans have a higher borrowing limit as compared to unsecured loans.
An unsecured loan, as the name suggests, can be borrowed without loan collateral. The borrowing limit is lower since no collateral is involved. The interest charged on the loan amount is usually higher. If the lender defaults on a loan payment, the lender has few options to recover the amount. Personal loans and credit card loans are examples of unsecured loans. However, personal loans can be both unsecured and secured.
What Are the Contents of a Loan Agreement?
A loan agreement contains the following contents:
1. Details About The Lender And The Borrower
Getting the essential details of the parties involved is important. The agreement should include information about both the borrower and the lender. Some of them are:
- Phone numbers
- Social security numbers
- The loan amount
- The principle amount
2. Rate Of Interest
Lenders charge a mutually agreed-upon interest rate on the borrowed amount as compensation for the risk of lending money to the borrower.
3. Contract Length
The lifespan of the loan agreement generally depends upon a schedule. This schedule determines the borrower's monthly amount by dividing the entire loan amount by the number of payments required to repay the loan amount. Interest is added to each monthly payable amount. It is advisable to keep the loan duration smaller. This is because the higher the loan term length, the more interest you have to pay against the loan amount.
4. Loan Repayment Method
The loan payment method highlights how the borrower wants to repay the loan to the lender. The borrower can do it in several ways, such as:
- Regular payments are made over a fixed period.
- Periodic payments are made, especially to pay off the interest.
- Recurring payments are made to pay the principal and the interest.
5. Loan Repayment Schedule
There are three ways to repay your loan.
Installment payments are the most common repayment method. You'll be required to make periodic payments until all interest and principal are paid.
Payment on demand is when your lender can decide to require repayment at any given time after giving you advance notice based on what is in your agreement.
Payment at the end of your loan term is an agreement that states a final date when all the accrued interest and principal are due in one sum.
6. Missed Or Late Payments
Depending on your loan agreement and the law, your late payment might cause a late fee from your lender. After 30 days, if you still haven't made the payment, it could appear on your credit report and affect your credit score. If you don't pay your loan for a longer time, the remarks on your report will get progressively worse.
You can avoid more severe consequences by communicating with your lender to discuss options and solutions or by making the payment within 30 days.
When Can You Use a Loan Agreement?
A loan agreement is beneficial any time an amount is borrowed. This is because the agreement legally formalizes the loan-taking process and protects the interests of both parties involved in the transaction. Although loan agreements are helpful for every lending situation, they are typically used for loans that are repaid over a predetermined period. Here are some of the loans that most commonly require a loan agreement:
- Student Loans
- Real estate loans like mortgages
- Private or personal loans between family members or friends
- To finance large purchases such as vehicles or furniture
- Commercial or business loans such as capital loans to open a startup company
What Are the Loan Agreement Terms to Review?
While signing the loan agreement, make sure to review the following agreement terms:
1. Acceptable Uses
Make sure that you can use the borrowed amount for your intended purpose. This is because many types of loans can be used for a single purpose. For instance, a car loan can be used only for buying cars and not for any other purpose. Similarly, a personal loan can be used for several purposes, such as to pay medical bills, debt consolidation, car repairs, home improvements, unexpected expenses, or to pay back family and friends.
2. Entire Agreement Clause
This agreement clause means that the final agreement will prevail over and above any previous oral or written agreements that might have been made during negotiations.
3. Severability Clause
The severability clause highlights the terms independent of each other within the contract. This means that even if a part of the agreement is deemed unenforceable, void, or unconstitutional, other conditions will continue to be enforceable.
4. Choice Of Law
This determines the difference between laws in two or more jurisdictions. As an example, laws governing a specific part of a loan agreement in a certain state may differ from the same law in another state. It's essential to identify which state or jurisdiction laws will apply.
Are Witnesses Required for a Loan Agreement?
A witness is not mandatory to sign a loan agreement. However, if you wish to add an extra layer of protection to the loan transaction, you can ask any person, preferably someone you know to act as a witness to the process of loan execution. However, the witness needs to be 18 years of age or above and needs to be of sound mind.
Does a Loan Agreement Need to Be Notarized?
You can get the agreement notarized if you want extra protection, but it is not necessary. Notarization is the process whereby a professional notary verifies and confirms that the people signing any legal document are who they claim to be. The notary puts a stamp of approval on the document.
You can use a notarized loan agreement as a security agreement that can come in handy to tackle sensitive cases. It will act as solid legal evidence that can be used in a court of law to defend against loan-related disputes.
Loan Agreement Vs. Promissory Note
|A loan agreement is a contract between the lender and the borrower, which formalizes the loan process's execution and outlines the terms and conditions applicable to the loan.
|A promissory note can be considered a written promise or an IOU (I Owe You) for any loan, whether a car loan or a personal loan.
|It is a legally bound contract.
|A promissory note is also legally binding.
|It usually needs to be drafted by the lender.
|It is made by the borrower.
|Both the lender and the borrower sign a loan agreement.
|Only the borrower signs a promissory note.
|The loan repayment terms and conditions outlined in a loan agreement are complex.
|The loan payment terms and conditions are straightforward in a promissory note.
Whether the loan is between family members, friends, or corporations, you must draw out a loan agreement to eliminate any chances of conflict in the future. Read all the terms and conditions carefully before finalizing a loan agreement, whether you are the borrower or the lender.
Joseph Priebe takes pride in assisting audiences with his articles to help them make sound financial decisions.
With over ten years of experience writing financial content his goal at CASH 1 has always been creating engaging and easy-to-digest information for anyone searching for immediate or long-term monetary solutions.
When Joseph is not writing about personal finance, you can find him photographing the Southwest United States with his 4x5 Graflex Crown Graphic camera. He is based in Phoenix, Arizona.