Traditionally, “the lender” – the institution facilitating the transaction and providing the loan, determines the terms of a loan agreement. In less formal circumstances however, where a loan takes place between small businesses for example, the terms of a loan agreement is, to some degree, at the discretion of “the borrower”. In instances where either the lender or borrower has the burden of setting the terms of a loan agreement, there are a number of crucial terms to take into consideration to ensure your agreement is ethical, reliable, and in the parties’ best interest.
When setting the terms of a loan agreement, the lender should first determine whether the borrower is eligible for a loan (by ensuring that he or she can adequately repay the loan). The process of eligibility can range from valid photo identification and proof of employment to a paystub or a credit check. In extreme circumstances, the lender may request collateral as a form of insurance. The lender’s objective is to ensure that he will indeed be repaid. Consequently, if the borrower does not pass the test of eligibility no further steps should be taken to draft or execute the agreement.
A loan agreement should include a term pertaining to interest. Interest is defined as money paid regularly at a particular rate for the use of the money lent or for delaying the payment of the debt. In other words, it is a fee for the loan transaction itself. There are two main types of interest rates, namely fixed interest or floating fee rates. The former is a set rate that does not change throughout the course of the loan. For example, the borrower may have a 10% interest rate on the loan in its entirety. The latter is based on an interest margin in addition to a benchmark rate. For example, the borrower may have a margin interest rate of 5% and a benchmark rate. Floating fee interest rates are less frequent as they are only used for complex loans. Most loans will adhere to a fixed interest principle with payments occurring either at the end of the term of the loan or at each pre-determined interest period.
A thorough loan agreement will also stipulate a course of action for default interest. If the borrower fails to make interest payments, the lender may increase the interest rate as a penalty. However, if the increased interest is burdensome and unreasonable, a governing body or court of competent jurisdiction may deem the term unenforceable.
Is The Loan Secured Or Unsecured
When setting the terms of a loan agreement, some consideration should be given to the status of the loan, particularly whether it is secured or unsecured. Determining whether a loan should be secured or unsecured depends on the nature of the transaction. For example, home loans and large business loans are secured. This means that the borrower pledges an asset as collateral for the loan. On the other hand, unsecured loans facilitate loans of much smaller quantity such as payday loans and small business loans of $5,000.00 or less. Unsecured loans pose a greater risk to the lender. Thus, it is imperative that the subsequent terms of the agreement accommodate the risk (interest rate and default clauses).
Will the borrower have a fixed repayment schedule or will the agreement allow for flexibility? A prepayment clause will allow the borrower to repay his loans earlier than the anticipated end date. Some loan agreements may reward early repayment by decreasing the interest rate. Though a prepayment clause is at the discretion of the lender, it is not uncommon for a loan agreement to make it mandatory.
Bilateral vs. Syndicated Loan
Finally, when setting the terms of a loan agreement, the clauses should reflect whether the agreement is bilateral or syndicated. Most loans are bilateral, occurring between a borrower and a single lender. However, where the loan is of a significantly large amount or the lender is a corporation or major investor, the loan must be identified as a syndicated loan.