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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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.
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.
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:
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:
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.
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.
Interest-only loans can lead to lower initial payments, but they may also be scams that increase your penalties and leave you with no recourse.
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.
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.”
APRs apply solely to the portion of your loan you still owe, whereas factor rates apply to your entire loan.
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.”
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.
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.
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.”
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.
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.
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.
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.
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.
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.
Below is a glossary of loan terms you’ll likely encounter as you review the terms of your business loan agreement.