Loan Agreement Essentials

A loan agreement is a contract between two parties – a lender and a borrower – that governs the loan being extended by the lender to the borrower. This agreement is a binding contract between the two parties that essentially formalizes the loan process. The document itself can come in many types though. Simple loan agreements between family, friends and relatives can consist of a promissory note where the borrower agrees to borrow a certain sum of money and pay a stipulated amount of interest for a specific time period. However, this can vastly increase in complexity for more detailed contracts such as mortgages, automotive purchase loans, and payday advance loans. On the corporate side, the agreement between a lender and the borrower is called a credit agreement and can often run into the hundreds of pages.

Why is it important?

Simply put, formalizing a loan agreement at the onset of extending the loan is in the best interests of both parties. On the lender’s side, it provides a formal document that enables him or her to recoup their money if the borrower refuses to pay and/or provides alternatives if the borrower is deemed insolvent. In a worst-case scenario, they can even take the borrower to court, and assuming the language used in the loan agreement is sound, recoup their money through the legal system.

On the other side of the coin, the benefits of the loan agreement to the borrower include a legal document which states exactly how long the loan term is for, as well as the amount of interest to be paid, collateral put up, consequences of non-payment etc. Thus, in the event of a disagreement between the lender and the borrower, the loan agreement is the full and final authority on the next course of action to protect the interests of both parties.

Who drafts the loan agreement?

Generally speaking, the lender is responsible for drafting up the formalized document and obtaining signatures from the borrower. In Canada, federally regulated financial institutions (FRFIs) are obligated to provide certain financial information depending on whether the loan in question is a fixed rate or variable rate loan. Most retail banks and lending institutions fall under the umbrella definition of the FRFIs.

Fixed-rate personal loan agreement components

A fixed-rate loan is one where the borrower has to pay a pre-defined rate throughout the course of the loan term. This rate is calculated based on market factors such as the prevailing interest rate as well as individual factors such as the borrower’s risk profile. Once loan terms are agreed upon though, the financial institution must provide the loan contract with the following items (at a minimum):

• Principal amount: This refers to the total amount being borrowed on Day 1 of the loan.
• Annual interest rate: The cost of borrowing the funds usually expressed as a percentage. Current regulations stipulate that this must be expressed on an annual basis. Hence, even if it is expressed somewhere else in the loan agreement on a weekly, monthly, quarterly or semi-annual basis, ensure that you identify the annual rate as that is effectively what you will be paying.
• Annual Percentage Rate (APR): The cost of borrowing the funds, usually expressed as a percentage and including fees such as service charges and administrative fees.
• Term: How long the loan is being extended to the borrower for. This is normally expressed in years or months (weeks in a few cases).
• Advance date: This refers to the date where interest starts getting charged on the loan
• Payment schedule: The cumulative amount of the principal plus interest payment(s) due and on which date.
• Amortization period: Note that this differs to the loan term. The loan term is the length of time that the borrower is committed to the lender for the rate and its associated terms and conditions. The amortization period, on the other hand, is the length of time (normally expressed in years or months) that it will take to pay off the loan in full. In Canada, most maximum amortization periods are 25 years.
• Other fees: The other fees section of the loan agreement details administrative or penalty fees that would have to be paid by the borrower to the lender for certain events. For example, an administration fee can be levied by the lender to cover the costs of servicing the loan year on year. A penalty fee such as an insufficient funds fee may be charged in case the borrower does not have the requisite funds in his or her account to make the minimum payment as per the payment schedule.
• Total payments: The cumulative sum of principal and interest payments that you would be making over the life of the loan. This needs to be broken down further by total principal payments and total interest payments.
• Collateral: A description of the assets being pledged as collateral to secure the loan in case of the borrower defaulting on their payments.

Variable-rate personal loan agreement components

• Principal amount: This refers to the total amount being borrowed on Day 1 of the loan.
• Annual interest rate: The cost of borrowing the funds usually expressed as a percentage.
• Benchmark rate: How the interest rate is calculated. Normally, there is an underlying reference rate (such as the Prime rate) that the lender uses to determine a rate for the borrower
• Annual Percentage Rate (APR): The cost of borrowing the funds, usually expressed as a percentage and including fees such as service charges and administrative fees.
• Term: How long the loan is being extended to the borrower for. This is normally expressed in years or months (weeks in a few cases).
• Advance date: This refers to the date where interest starts getting charged on the loan
• Payment schedule: The cumulative amount of the principal plus interest payment(s) due and on which date.
• Amortization period: The length of time (normally expressed in years or months) that it will take to pay off the loan in full.
• Other fees: The other fees section of the loan agreement details administrative or penalty fees that would have to be paid by the borrower to the lender for certain events. For example, an administration fee can be levied by the lender to cover the costs of servicing the loan year on year. A penalty fee such as an insufficient funds fee may be charged in case the borrower does not have the requisite funds in his or her account to make the minimum payment as per the payment schedule.
• Total payments: The (estimated) cumulative sum of principal and interest payments that you would be making over the life of the loan. This needs to be broken down further by total principal payments and total interest payments.

When signing a loan agreement, always ensure that you are obtaining a loan with a lender that has your best interests in mind. The team at Magical Credit would be happy to walk you through specific questions that you may have. Please feel free to reach out!