A loan agreement, or “note,” is a standard and straightforward contract that typically 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 particular type of collateralization. A loan agreement does not have to involve a bank or other financial institution, such as a mortgage loan. Many loan agreements are between two individuals, two businesses, or a combination of the two. It is routine for banks and other financial institutions to perform both background and credit checks and 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 standard practices can result in a company or individual lender having difficulty recovering funds on a note or loan agreement in the event of an incurable default of payment.
The question then becomes how can an individual or business lender protect itself in a loan agreement?
It is more common to see notes or loan agreements between family members, neighbors, or close friends in an individual or small business setting. There is nothing inherently wrong with such a transaction, but the parties need to treat it as a standard business transaction and take appropriate precautions. A credit and/or background check, although recommended, may not be practical in this type of social dynamic. Consequently, it is more critical in such a setting to be sure that you understand fully what the money is being used for and how the borrower is planning to generate the funds to pay you back as a lender. If this is for a business venture or investment, you should evaluate the business plan to ensure that it makes sense before agreeing 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 straightforward 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 to guarantee the borrower’s default amount. 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 essential considerations in any loan agreement is collateral. Incredibly, the number of times individual and small business lenders get into trouble for failing to collateralize a loan 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 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 you are likely to be deemed an unsecured creditor without collateral. As such, any amount owed to you could be at risk of being discharged if the borrower or debtor went into bankruptcy.