Loan Agreement 101: Crafting a Watertight Contract

People frequently enter loan agreements, whether they are business owners wanting to buy a new piece of machinery or individuals wanting to purchase a new car. Loan agreements are binding contracts between parties that specify the terms on which the loan is based and serves to formalise the loan. Loan agreements can be distinguished based on whether they are personal or commercial loans or whether they are bilateral or syndicated loans. Despite how common loans are, many do not know how to draft a loan agreement or which terms to look out for when reviewing a loan agreement. 

This article will provide you with a comprehensive overview of how to write a loan agreement by covering the following key points: 

• What is a loan agreement?

• What are the different types of loan agreements?

• Why have a loan agreement?

• How to write a loan agreement?

Make sure you read until the end, as we will be providing free template loan agreements for you to navigate your business and personal life with ease and confidence.

What Is A Loan Agreement?  

A loan agreement is a contract between a borrower and a lender. 

Loan agreements serve as a written repository of the terms and conditions of which the lender has agreed to lend money to a borrower. Loan agreements specify, amongst other things, the term of the loan, the repayment procedures, and details on interest payments payable by the borrower on the loan.

What Are the Different Types of Loan Agreements?

Loans can be bilateral or syndicated. Bilateral and syndicated loans are different due to the different number of lenders involved.

In a bilateral loan, there is a single lender – often one bank or financial institution. As such, there are only two parties involved in the transaction – the borrower and the lender. 

For a syndicated loan, on the other hand, there are multiple lenders involved, this usually being several banks or financial institutions. Each lender puts up a portion of the loan, which collectively goes to the borrower. This is usually used when there are large sums involved, as an individual bank does not want to risk making a loan of such a large sum to a single borrower. Instead, banks will provide smaller amounts which, when collated provide the borrower with the borrower's desired amount. 

Loans can also be distinguished based on whether they are commercial or personal.

A commercial loan agreement is an agreement between a borrower and lender that is made solely for business purposes. In a commercial loan agreement, an individual or organisation enters into an agreement with a lender and agrees to certain terms and conditions, for instance, the loan’s use and repayment, in exchange for the lender providing a sum.

Most often, the lenders for such commercial loans are banks or financial institutions. These financial institutions or banks tend to have their own standard form of a loan agreement, approved by their legal team. It is, therefore, very difficult for borrowers to negotiate changes concerning the terms found in standard form agreements.

A personal loan, on the other hand, binds an individual. It cannot bind any group, entity, or other organisation the individual represents. Additionally, the money borrowed by an individual through a personal loan can be used for any purpose. Since personal loans are more flexible and not tied to a specific purchase or purpose, they are often unsecured. This means that debt is not related to any assets, such as home mortgages or car loans.

The lender in personal loan agreements can be a financial institution, bank or even an individual such as family members or friends. As with commercial loans, if the lender is a financial institution or bank, these organisations will generally have standard form loan agreements which have been approved by their legal teams. It will be very difficult for you as a borrower to negotiate terms as part of this standard form agreement.

However, if the lender is an individual – such as family members, or friends – the borrower might have more scope to negotiate the terms of the loan agreement.

Why Have A Loan Agreement?

As we briefly touched on, a loan agreement is a written repository of the terms and conditions of which a lender is willing to make a loan to a borrower.

The purpose of having a loan agreement is to clearly define what the parties involved are agreeing to and what obligations they each have.  

This written repository of terms protects the lender, making it easier for the lender to enforce the agreement should the borrower not make payments according to the agreement.

The borrower will also likely find a written loan agreement useful as it spells out their specific rights and obligations under the loan, giving them greater clarity and increasing the likelihood of compliance with the agreement. 

How to Write A Loan Agreement/Loan Contract/Promissory Note?

Invariably, the exact terms and conditions found in a loan agreement/ loan contract/ promissory note will vary depending on the circumstances, such as the amount being loaned and the financial health of the borrower. However, most loan agreements feature the same few core terms and provisions.

The core terms and provisions include the following:

1. Definitions and Interpretation

2. Borrowing Mechanics

3. Conditions Precedent

4. Representations and Warranties

5. Covenants

6. Events of Default

7. Miscellaneous Provisions

1. Definitions and Interpretation 

Like other agreements, loan agreements typically start with a definition of terms that will be used in the loan agreement.

These definitions must spell out with accuracy and precision. This is because many of these terms will be constantly repeated throughout the agreement and will influence the meaning of many terms in the agreement. 

Other rules for interpretation are also featured in this section. This part, in effect, describes whether the use of any language in the agreement is to be limited to a particular signification or not.

Some examples of rules for interpretation include terms stating that any use of the singular form should be interpreted as including the plural form. Another common term that might be included would dictate that the use of a particular gender should be interpreted as including the other gender. 

2. Borrowing Operation

The next stage in a loan agreement outlines how the loan should work. Among other things, this section will include details such as:

• The type of loan agreed upon,

• The principal sum loaned under the agreement

• Terms governing interest and other fees will also be included.

• The repayment schedule

Particular attention should be paid to the different repayment schedules. This is because of the many variations of repayment schedules which may be proposed by a lender. Some such variations of repayment schedule include: 

(A) Instalment payments

This variation of repayment arrangement involves the payment of the principal and interest at regular intervals throughout the lifetime of the loan. 

For example, if the borrower needs to make $500 worth of payments, this might be broken down to $300 as the outstanding principal sum and $200 as interest. 

(B) Instalments with a final balloon payment

This repayment arrangement involves payments of interest being made at regular intervals. The principal, however, will not be paid off at regular intervals. Instead, the principal sum will be paid off in whole upon maturity of the loan. 

(C) Lump sum payment (entire sum due on a specific date) 

Under this payment arrangement, the entire amount, including both interest and the principal sum, will be paid all at once on a specific date. 

(D) Due on demand 

Under this arrangement, the entire amount, which includes both interest and the principal sum, is due whenever the lender requests repayment of the sum. 

3. Conditions Precedent

Next, a section outlining the conditions precedent of the loan will be stated. The conditions precedent section outlines conditions that must be met or events that must happen before the loan can be considered binding between the borrower and lender.

These specific conditions will depend on the loan at hand. 

Typically, conditions will pertain to the need for the production and delivery of certain documents to be as specified. Another typical condition is the provision of assurances that events have occurred. 

4. Representations and Warranties

Representations are statements that are true on the date of making the statement inducing the entering of a contract. Warranties are statements of fact stated to be true on the date of the contract.

Representations and warranties are used by a lender to reduce the risk when lending to the borrower. They allow the lender to gather important information – usually information concerning the financial standing of the borrower.

Lenders also often seek to ensure that the statements of fact made through the representations and warranties remain true throughout the lifetime of the loan. Lenders will do this by specifying that the representations and warranties must be restated by the borrower at certain intervals – e.g., every calendar month.

The borrower should resist any attempt to have the representations and warranties restated at an interval or deemed repeated since the result could be that the loan becomes, in effect, a demand loan because of circumstances outside the borrower’s control. 

With regards to representations, more generally, the borrower should try to negotiate to have any representation regarding the accuracy of any information provided by it to exclude information casually supplied.

5. Covenants

A covenant is a condition that imposes positive and negative duties for the borrower to fulfil throughout the term of the loan. Covenants, therefore, have a continual effect throughout the loan terms.

They are used by the lender during the lifetime of the loan to monitor the activities of the borrower and stop the borrower from taking any action that may make it less likely that the loan will be repaid. The aim of doing this is to ensure that the borrower remains creditworthy during the period of the loan agreement. 

Given the purpose of covenants in loan agreements, it is not surprising that covenants in loan agreements often impose a positive duty on a borrower to provide information regarding its financial position to the lender. 

Generally, covenants are very onerous. This is because by imposing a negative duty (a duty not to do something) or a positive duty (a duty to do something), they restrict the capacity of the borrower to conduct their business or personal affairs with freedom.

To lessen the onerousness of a covenant, any undertaking to provide lenders with information under a covenant should be limited to exclude information:

• Reasonably considered by the borrower to be of a confidential nature;

• Which would require the consent or approval of a third party;

• Which would necessitate similar disclosure being made to the public

6. Events of Default

Loan agreements include a section outlining particular ‘events of default’. If these stated events occur, the lenders can exercise their remedies, including accelerating the repayment of outstanding debt, enforcing security interests, and cancelling further amounts which have been agreed to be given to the borrower.

The borrower usually negotiates ‘grace periods’. They should be negotiated to run from when notice is received by the borrower of the breach constituting the event of default rather than from when the relevant breach occurs.

Furthermore, the borrower should also negotiate a provision to the effect that the loan can only be accelerated when the relevant event of default has occurred and is continuing. Otherwise, the banks might be able to accelerate despite the relevant breach being remedied – which is completely inequitable.

7. Miscellaneous Provisions

Loan agreements tend to also include other miscellaneous ‘boilerplate’ provisions. Boilerplate provisions are a standard set of clauses that appear at the end of every contract.

Important boilerplate terms in a contract include those specifying details regarding the provision of notices, the execution of the agreement in counterparts, the governing law and jurisdiction of the agreement, the survival of certain provisions etc.

For an in-depth explanation of boiler-plate clauses, please refer to our dedicated blog entry here. 

TEMPLATES:

You should be aware by now that loan agreements are difficult to write. We would therefore advise that you use a template to write your loan agreement.

We have created comprehensive loan agreement templates suitable for commercial, personal, and other purposes. They are customisable for your use. 

You can find and select a suitable commercial loan agreement here. 

You can find and select a suitable personal loan agreement here. 

Disclaimer: Please note that this is a general summary of the position under common law and does not constitute legal advice. As the laws of each jurisdiction may be different, you may wish to consult your lawyer.