June 28, 2013
A loan agreement, or “note”, is a simple and common contract that typical identifies the lender or creditor, a borrower or debtor, the principal amount being lent, an interest rate, the repayment terms, and in some cases, a trustee, which is often dependent on if the loan agreement has a certain type of collateralization. A loan agreement does not have to involve a bank or other financial institution, such as a mortgage loan. In fact, many loan agreements are between two individuals, two businesses, or combination of the two. It is routine for banks and other financial institutions to perform both background and credit checks as well as to take collateral on any note or loan agreement they issue. However, this is not always common practice between individuals and/or businesses. Unfortunately, failure to follow these common practices can result in a business or individual lender having difficulty recovering funds on a note or loan agreement in an event of an incurable default of payment.
The question then becomes how can an individual or business lender protect itself in a loan agreement?
In an individual or small business setting, it is more common to see notes or loan agreements between family members, neighbors, or close friends. There is nothing inherently wrong with such a transaction, but it is important for the parties to treat it as a standard business transaction and to take the appropriate precautions. A credit and/or background check, although recommended, may not be practical in this type of social dynamic. Consequently, it is more important in such setting to be sure that as a lender you understand fully what the money is being used for and how the borrower is planning to generate the funds to pay you back. If this is for a business venture or investment, you should evaluate the business plan to ensure that it makes sense to you before you agree to anything. If you believe the borrower has the means to pay you back and you wish to create a loan agreement, be sure that all of the terms agreed to by the parties are laid out in a clear and easy to understand contract or agreement which is executed by both parties, preferably in front of a notary public.
Some of the key terms that a loan agreement should identify in detail include how interest is calculated, repayments dates, and what occurs in the event of a default. It may also be worth putting in collection or prevailing party attorney fee language into the loan agreement to deter the borrower from defaulting on payment. Another consideration is to have other family members or individuals sign the loan agreement as well to guaranty payment in the event of a default by the borrower. This addition can be in the form of a surety or guarantee agreement, as we have discussed in more detail in a previous post.
One of the most important considerations in any loan agreement is collateral. It is amazing the number of times individual and small business lenders get into trouble for failing to collateralize a loan, which can be a tremendous financial burden on a lender who did not get repaid. In some extreme cases, it can even force the lender to seek relief through bankruptcy. Typically, collateral is some form of property that will be transferred to the lender in the event of an incurable default by the borrower. Common examples of collateral include a house or a car. Ideally, you would want the collateral to be valuable enough to cover the entirety of the amount owed or outstanding on the note. Further compounding the importance is that without collateral, you are likely to be deemed an unsecured creditor and as such, any amount owed to you could be at risk of being discharged in the event that the borrower or debtor went into bankruptcy. As a result of the dangers and considerations involved, it is extremely important to work with someone experienced in contracts and loan agreements. You do not want to find yourself struggling financially, especially to the point of filing for bankruptcy protection, because you did not take the time to ensure that your loan had adequate repayment assurances.