Make a bad investment? You're only going to lose the money you put down. Sign a shoddy loan agreement? You may end up in bottomless debt.
For thousands of New York taxi drivers, both ended up being the case. According to a New York Times expose published in May 2019, much of the profession's financial ruin – and, tragically, rampant suicide rates – can be traced to the deliberate overpricing of taxi medallions (the city's taxi license) and the predatory loans cabbies took out to afford them.
It’s hard to argue that the taxi drivers weren't taken advantage of, with many lacking the English-language skills to do their due diligence. The problem is that not all predatory loans are unlawful. While usury laws can cap interest rates and payday loans are banned in some states, many unethical lenders are still able to operate within the realm of legality. This is why it's important to thoroughly understand your business loan agreement and ask questions before signing on the dotted line.
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What is a business loan agreement?
A business loan agreement – also known as a commercial loan agreement – is a contract between a lender and a borrower that outlines the details of each type of business loan.
"The agreement specifies the promises of both parties: the promise of the lender to give money and the promise by the borrower to repay that money" under the agreed-upon terms, according to Paul Sundin, CPA, a financial strategist and consultant at Emparion.
Typically, a business loan agreement covers a loan used to start or expand a business, or to buy a building or equipment for a business. It can also cover a business loan earmarked for purchasing inventory.
How does a business loan agreement work?
After approving a loan application, the lender draws up a business loan agreement and sends it to the borrower for review and signature. This often happens via email.
The business loan agreement becomes legally binding the moment it has been signed by the lender and borrower. This means the lender is now obligated by law to provide a loan in the amount and at the rate noted in the business loan agreement, and to do so under all terms stated in the contract. At the same time, the borrower becomes obligated to repay the loan in the manner described in the agreement, and to meet any additional requirements the lender has specified in the paperwork.
What information should a business loan agreement include?
Failure to read the fine print of a business loan agreement can have life-altering consequences. If you're a small business owner who has been approved for a business loan, the hard part may be over, but don't let your jubilance get the best of you. Read the fine print. Scan the document to ensure it contains the following information:
- Name of lender
- Borrower information, including the name of your business and the names of the business representatives signing for it
- Dates, including the date the business loan agreement is executed and the date by which the loan must be fully repaid
- Loan amount – the total sum provided by the lender in the form of a loan
- Down payment amount, if you've made one
- Interest rate
- Fees, such as loan closing or administrative fees
- Repayment terms, including payment schedule (e.g., on a certain day of each month), payment method and prepayment penalties
- Information about collateral such as equipment, inventory, vehicles or real estate that you've put up as a condition of obtaining the loan
- Other lender-defined requirements to obtain the loan, such as a guarantor or a blanket lien
- Events of default – a description of any actions the lender will initiate if you default on the loan, like taking possession of collateral, making the remaining balance of the loan due immediately, or other legal action
Now that you've made certain all the necessary details of your business loan agreement are present and accounted for, it's time for the nitty-gritty. You'll know you truly understand the document if you can answer these seven questions:
1. Is the interest rate fixed or variable?
In a variable interest rate loan, the borrower pays the market's interest rate plus or minus a fixed percentage. A common variable rate for business loans is the Wall Street Journal prime rate plus 2.5%. As the prime rate changes, so does the interest a borrower pays.
A fixed interest rate is not affected by the market – the percentage remains the same. Variable rates tend to accrue less interest than fixed rates, but they come with greater risk, especially for loans with long amortization periods. A fixed interest rate secured when interest rates are low can shield borrowers from market changes.
Look out for interest-only loans.
In a standard amortizing loan, borrowers pay off some of their principal, or the amount initially borrowed, in addition to interest for each installment. An interest-only loan is exactly what it sounds like, but it doesn't last forever. After an initial interest-only period, borrowers can either convert to a standard amortizing loan, pay off the whole debt in one balloon payment, or refinance. [Interested in finding the best business loan for your small business? Check out our best picks and reviews.]
The advantage of interest-only loans, for those willing to take the risk, is that the initial required payments are lower. This can be a lifesaver for a cash-strapped small business. Like any other risky lending practice, however, they can also be used by predatory lenders to mislead inexperienced borrowers. This was one of the many schemes The New York Times reported was used against taxi drivers by leading borrowers to think they were paying off their debts when they were only paying interest.
2. What is the annual percentage yield?
The annual percentage rate (APR), a combination of the total interest payable and all other fees averaged out over the term of the loan, provides a useful way to evaluate and compare loans with one quick figure. What APRs don't account for is compounding interest, which is why borrowers should look at the annual percentage yield (APY), also known as effective annual rate (EAR), for a more accurate read on what they'll have to pay. Unlike the APR, which multiplies the interest rate by the number of times it's applied (e.g., quarterly or monthly), the APY includes compound interest, or interest paid on previous interest.
Since APYs are higher – not to mention harder to conceptualize – they're less likely to be quoted by lenders. If that's the case, you can use this online calculator instead.
Look out for factor rates.
It's common for short-term loans or merchant cash advances to quote interest in the form of a factor rate. This is not to be confused with APR. While the APR reflects interest charged on the remaining principal (meaning the more debt you chip away, the less interest you'll owe), factor rates reflect interest for the entire principal, regardless of the number of installments or how quickly it's paid off. Thus, a factor rate will accrue more interest than an APR of the same percentage.
That's something Glenn Read learned the hard way when financing his small business, Allegra Marketing Print Mail, after being turned down for a traditional bank loan.
"I was forced to take out merchant cash advances (MCAs) and high-interest line-of-credit loans just to meet payroll and keep the lights on," Read said. "One of the first MCAs I took out, the amount I was given was $40,000 and the payback was $56,000 for a one-year term." As it happened, the MCA had charged a factor rate of 40%. "It's important to understand the language of the nonbank lenders."
3. Whose credit rating is important?
Approval and terms of a business loan are often based on a combination of business and personal credit scores. For small businesses that haven't proven creditworthiness, the owner's personal credit score is critical.
"Few small businesses have a long enough track record to have a sufficient credit history," said Brian Cairns, who runs his own consulting company, ProStrategix Consulting Inc. After securing his own small business loan, Cairns now helps many of his clients do the same.
According to Cairns, personal credit concerns not just the founder, but any equity-holding partner. "If you or one of your partners owns a material part of the business (usually about 20% or more), your personal credit can affect your chances of getting a small business loan."
Look out for unjustified risk-based pricing.
A subprime loan, or a loan given to a borrower with poor credit history, will often include a risk premium of higher interest rates, higher fees or both. Some predatory lenders take advantage of this by telling the borrower they have bad credit in order to ramp up interest rates, a practice known as unjustified risk-based pricing. This is an easy trap for inexperienced borrowers unaware of their own creditworthiness. Knowledge of your personal and business credit ratings helps ensure you're getting a fair price.
4. Do you have to put up collateral?
A secured loan means that the borrower must offer some sort of asset as collateral – something the lender can take over in case of default. In mortgages, this is the property itself. An unsecured loan, meanwhile, does not have any collateral.
While unsecured loans in the form of credit cards and student loans are common, business loans almost always require some sort of guarantee. Only well-established companies with long credit histories stand a chance of getting an unsecured business loan. [Read related article: Unsecured vs. Secured Business Loans]
Look out for personal guarantees.
It's common for small business loans to require a personal guarantee for the same reason personal credit scores come into play: Many small businesses have yet to build creditworthiness on their own, making the owner liable instead. On top of that, small businesses may lack assets to use as collateral. However, banks may not always be upfront about the owner's personal liability.
"Most people don't read the fine print and can be surprised when they learn that they put some of their personal finances at risk," Cairns said. The assertion comes from his personal experience. "We caught it in our fine print that the bank was using our founders' personal retirement savings as a personal guarantee for the loan."
5. What is the payment and amortization schedule?
Interest rates and APR aside, business loans can vary by payment schedule. This includes not just the number of payment periods per year, but the inclusion of grace periods, late fees and prepayment penalties.
One thing lenders don't often specify in the fine print is the amortization schedule, or the schedule of how much of the debt is repaid each month. Remember that in each installment, some of the money you are charged pays off the principal, or the amount of money you were initially lent, and some of it is paying off the interest, which you can think of as a fee for the lender's services. As a loan matures, the proportion of each installment paid toward principal increases, while the proportion paid toward interest decreases.
The difference between an amortization schedule and a payment schedule is that, with the latter, the amount of principal and interest you owe each installment is added together into one total amount charged. An amortization schedule, meanwhile, lets you see the exact breakdown, showing how much debt you still hold at any given time during the life of the loan.
It's important to know where you stand with your debts, since they can affect your credit rating. A savvy borrower can also use the amortization rate to calculate how much they'd save in interest by paying off their loan early. Thus, it's a good idea for borrowers to plug their loan details into an online amortization calculator.
Look out for prepayment penalties.
Penalizing a borrower for paying a loan off early may sound counterintuitive, but the earlier you repay the principal, the less interest you'll have to pay over the life of the loan if it's a standard amortizing loan. Since lenders rely on that interest to make a profit, a prepayment penalty offsets some of that lost future interest. The good news is that, while common for mortgages, prepayment penalties are rarely part of small business loan agreements.
6. What is the lender's definition of default on payments?
Some borrowers will pore over most of the fine print word by word, only to give a cursory glance to the part about defaulting – no one wants to entertain that possibility. However, some lenders may have strict interpretations of "default," creating expensive mistakes down the line. This is why Jared Weitz, founder and CEO of small business lender United Capital Source Inc., stresses the importance of doing your homework.
"One piece of language and content to look out for is the time period allowed to make amends after receiving a default notice," Weitz said. "If you read this prior to signing and default your loan, you will already know what to do and how quickly it must be done."
In some instances, a borrower could pay on time and still go into technical default. This is a result of violating other terms of the loan, such as failing to provide tax returns or taking on additional debt.
Look out for confessions of judgment.
A confession of judgment (COJ), or cognovit vote, is a written agreement signed by the borrower that forfeits their rights to dispute any actions taken by the lender upon default. This means that if a borrower defaults, the lender can present the COJ in court and obtain a judgment without the borrower ever being notified, let alone given the opportunity to defend themselves.
"These days, it seems the No. 1 predatory lending scheme that SMBs are prone to is the use and misuse of confessions of judgment," Weitz said.
According to Weitz, such predatory lenders profit by enforcing the COJ as soon as the business owner defaults, before the owner even gets the chance to cure the default in the time specified in the loan agreement. "These predatory lenders go into the financing agreement with the intention of default so that they can seize the business and personal assets of the business owner."
Luckily, COJs are not a necessary evil. "There are many lenders out there that will work with you without the use of a COJ, so when shopping around, make sure you mention that you will not agree to any terms that involve a COJ," Weitz said.
7. How does the lender make money?
The best thing small business owners can do to get a fair loan agreement is to determine where the lender's profits come from. A fair lender should be turning most of their profit from interest rates that are reasonably based on the borrower's credit history.
Look out for lenders raking in profit from penalties or seized collateral.
If the lender earns more money this way than from interest, they have an incentive to reverse-engineer loan agreements to force borrowers into default. This is exactly how many predatory lending schemes are conceived – which is why no borrower should enter a contract in which the lender profits from their failure.
It's unlikely that your lender will let you read their income statement, but such loans are usually made obvious by the too-good-to-be-true interest rates, excessive fees, and lack of a grace period. You can also look up your lender's rating with the Better Business Bureau.
Business loan agreement terms to know
Below is a glossary of loan terms you'll likely encounter as you review the terms of your business loan agreement.
- ACH: Short for "Automated Clearing House," this type of loan payment is automatically withdrawn regularly from your business bank account.
- Amortization: "Loan amortization" is a fancy term for your payment schedule. An amortized loan requires equal, regular payments. The proportion of these payments that belong to interest and principal will vary, but the total amount should remain unchanged.
- APR: An APR is the total effective percentage you get when you divide all your yearly fees by your total yearly loan amount. It's a more accurate way of indicating your costs than looking solely at an interest rate or monthly fee.
- Balloon payment: A balloon payment is one large payment that covers the entirety of your loan upon your agreement's termination. All prior payments cover only the interest and fees.
- Blanket lien: A lender with a blanket lien on your assets can seize as much of your property as needed to cover their costs if you default on your loan.
- Co-signer: A co-signer is someone the lender can pursue loan repayment from if you default.
- Curtailment: A partial curtailment describes a larger repayment amount than initially expected, but one that's not the total value of the loan. A full curtailment is, as its name suggests, a full repayment.
- Default: When you default, you don't repay your loan according to the terms of your business loan agreement. As a result, the lender can take action against you or your co-signer.
- Deferred payment loan: Your payments on deferred payment loans begin in the future rather than immediately after your loan is serviced.
- Factor rate: For short-term loans and merchant cash advances, you'll multiply your initial loan amount by your factor rate to determine the total repayment amount you owe.
- Loan underwriting: Through this process, lenders determine whether you qualify for a loan and under what terms you qualify.
- Loan-to-value (LTV) ratio: For equipment financing or commercial real estate loans, your LTV ratio tells you how much of your purchase your loan will cover.
- Principal: Your principal is the amount of your loan before any fees or interest.
- Refinancing: When refinancing a loan, you pay it off with another loan. This allows you to switch to a loan with better terms.
- Servicing: This comprises all day-to-day loan matters, including initial funding, recordkeeping, payment collection and penalty assessment.
The takeaway is not that some loan terms are bad and you should never sign the agreement. It's that you should never sign a loan agreement until you understand every term in the fine print. Do not hesitate to consult a lawyer if that's what it takes.
Many of the same terms used in predatory lending schemes are also effective financing tools for borrowers willing to take a bit of risk, as long as they know what they're signing up for. By that same token, lenders deemed safe may still include unexpected terms and conditions that end up ruining borrowers who don't do their due diligence. In conclusion, read the fine print!
Max Freedman and Julie Ritzer Ross contributed to the writing and reporting in this article. Some source interviews were conducted for a previous version of this article.