Having clear loan terms helps borrowers understand their responsibilities. Misunderstanding any aspect of a loan agreement can lead to unintended financial consequences.
Loan terms can include the loan’s repayment period, fees and penalty charges, guarantor information, and reporting requirements. These sections are often overlooked by borrowers. However, they are vital to ensure loan compliance.
Lenders make money by charging interest on the loan amount. They take into account macroeconomic factors, a borrower’s credit score and debt-to-income ratio when setting these rates. Loan terms should clearly state the rate and fees, which are reflected in an annual percentage rate or APR, and should also describe how the loan will be repaid.
For instance, short-term loans often have lower interest costs and higher monthly payments than longer-term loans. However, it’s important to read the rules around how these rates and payments can change, as they aren’t always straightforward. This information can be found in the governing document, which may include terms such as when a borrower’s rate and payment will reset or whether there are prepayment penalties associated with paying off a loan before its term ends. These details can be especially important when evaluating mortgages. This is because mortgages are generally the largest loan a borrower will take on, and these documents are governed by strict legal guidelines.
The terms of a loan can include the amount borrowed, the repayment period, any fees or penalties that might be applied and the payment schedule. Loan terms can be very complicated, and it is important to take your time to understand them completely before agreeing to them.
If the loan agreement includes an amortization schedule, you should be able to see how regularly scheduled payments chip away at your remaining balance. These payments should be broken down by portion, showing how much is comprised of interest and how much is repaid on the principal.
Non-amortizing loans may also come with a payment schedule, but these are less detailed and are typically just a list of monthly payments that are due. The first four to six columns in the schedule should show each payment amount and date for the duration of the loan, but they won’t break down how much is interest versus principal.
Depending on the type of loan, collateral requirements may vary. Mortgages, for example, use a borrower’s home as collateral, while auto loans require a vehicle to be the security for the loan. Other types of collateral loans include those backed by credit cards, accounts receivable, inventory, investment portfolios and valuable property.
Typically, a lender will review and approve your collateral before granting the loan. Moreover, it will determine how much the collateral is worth and will provide you with an advance rate based on this value.
Aside from establishing the value of your collateral, a loan agreement should also outline negative covenants and reporting requirements. Kakebeen states that these sections usually detail everything a borrower can and cannot do, and set a framework for annual or quarterly reporting habits. They also detail what steps the lender will take in the event of default. This information can be important in determining whether a collateral loan is right for your business.
Lenders offer many different loan repayment options, including the traditional payment plan. They may also have a special repayment plan for those experiencing financial hardship. Repayment terms should specify when payments are due and the penalties for late fees.
The term length of a loan is another important aspect of the borrowing agreement. A longer-term loan increases the amount of interest paid, so it’s always best to opt for the shortest term possible.
Loan terms can also include covenants, which limit borrowers’ activities while repaying their debt. For example, lenders may prohibit borrowers from selling assets or making investments. This ensures that the cash they would otherwise use for these activities remains available for loan repayment, which satisfies the lender’s expectations. If a borrower breaches these covenants, the lender can pursue collection efforts to recover its money. This can damage a borrower’s credit score and make it difficult for them to secure future loans. This is why it’s essential to review loan terms carefully.