A loan agreement should accompany any loan of money. For loans by a commercial lender, the lender will provide the agreement. But for loans between friends or relatives, you will need to create your own loan agreement.
It is important to understand the various types of loan documents, and be aware of the ten provisions discussed below that should be included in a good loan agreement.
Loan Agreements, Promissory Notes, and IOUs
A loan agreement is any written document that memorializes the lending of money. Loan agreements can take several forms.
- The most basic loan agreement is commonly called an "IOU." These are typically used between friends or relatives for small amounts of money, and simply state the dollar amount that is owed. They do not usually say when payment is due, nor include any interest provisions.
- Another type of document is a promissory note, which typically includes an interest rate and terms of repayment. If the promissory note is secured by collateral, there is also a mortgage securing real property, or a financing statement securing personal property.
Usually, an IOU and a promissory note form are only signed by the borrower, although they may be signed by both parties.
A loan agreement is a single document that contains all of the terms of the loan, and is signed by both parties.
10 Essential Loan Agreement Provisions
There are 10 basic provisions that should be in a loan agreement.
1. Identity of the Parties.
The names of the lender and borrower need to be stated. It is common to also include each party's address.
2. Date of the Agreement.
The date of the agreement should be stated either at the beginning of the document, or directly above each party's signature.
3. Amount of Loan.
The principal amount of the loan is typically stated in the first paragraph.
4. Interest Rate.
Interest rates are stated as an annual percentage rate. Federal and state laws limit the amount of interest that can be charged, and if these rates are exceeded it may be impossible to have the agreement enforced by a court. On the other hand, not charging interest, or charging too low a rate, can create tax problems.
5. Repayment Terms.
There are three ways a loan can be repaid.
- Payment on demand. This is when the lender can decide to require repayment at any time, upon giving the borrower advance notice as provided in the agreement.
- Payment at the end of the loan term. With this arrangement, the agreement states a specific date at which time all principal and accrued interest is due and payable.
- Installment payments. This is the most common repayment method, especially for large amounts of money. It requires the borrower to make periodic payments, until all principal and interest is paid.
6. Default provisions.
The loan agreement should state what constitutes default, and outline the lender's remedies in the event of default. With a loan agreement that requires payment on demand, default occurs if the borrower fails to make payment when demanded by the lender (providing the required notice was given). With a lump sum payment required on a certain date, default occurs if the borrower fails to pay all amounts due on the date specified in the agreement.
With an installment loan, default occurs if the borrower fails to make any installment payment when it is due. A typical penalty for missing an installment payment is that the entire amount of principal and accrued interest becomes immediately due and payable. However, the agreement may also provide for a grace period, with a penalty for a late payment.
Default allows the lender to file a lawsuit for breach of contract. In addition to obtaining a judgment for the amount of the principal and interest due under the agreement, the agreement may also allow the lender to recover attorney fees, court costs, and other costs of collection.
There must be a place for each party to sign the document. It is also common to have places for witnesses to sign, or for a standard notary public attestation.
8. Choice of Law.
This sets forth the state whose laws will be applied in interpreting the agreement. For example: "Governing Law. This agreement shall be governed by the laws of the State of Delaware."
This allows the agreement to continue in effect even if one part of it is declared unenforceable. For example: "Severability. If any part of this agreement is adjudged invalid, illegal, or unenforceable, the remaining parts shall not be affected."
10. Entire Agreement.
This precludes a party from claiming that there are other agreements in addition to those stated in the loan agreement. For example: "Entire Agreement. This document constitutes the entire agreement of the parties. No representations or promises have been made except those that are set out in this agreement. This agreement may not be modified or terminated except in writing signed by the parties."
A loan agreement template may be found in numerous places online. These may be called by various similar names, such as personal loan agreement, private loan agreement, or family loan agreement. Just be sure that any form you use includes the ten essential provisions.