loan agreement can be a complex document, but it reduces the risk involved when loaning money. Before providing a business loan to another party, it is crucial to do your due diligence and have a well-drafted loan agreement in place. A loan agreement is an essential legal document that clearly outlines the arrangement between you and the borrower. This article outlines some of the key terms that you, as a lender, should be aware of in your loan agreement.

Operative Loan Clause

The operative loan clause outlines when and how you will loan the money to the borrower. It will also detail the specific amount of money (principal) that you will provide. This clause will also flag whether there are any conditions that the borrower must first meet before you can provide them with the loan. This clause might also detail the purpose of the loan and restrict the use of the loaned amount to specific purposes.

Interest

The interest clause sets out the interest rate on the loan you are providing. The interest clause will also include:

  • how often interest is calculated;
  • how the interest is applied to the amount owing; and 
  • when it is payable.

Interest rates can either be a fixed rate or a floating rate. A fixed-rate is set at a specific number, which does not change during the length of the loan. A floating rate is based on a benchmark rate and can have an interest rate margin added.

Default Interest

A default interest clause imposes a higher interest rate payable on amounts that the borrower pays late. If the borrower misses a payment or makes a late payment, they may need to pay extra interest. You can stipulate this in the default interest clause.

It is important to note that if the rate is excessive, there is a risk that the rate will be deemed a penalty rate and may therefore not be enforceable.

Secured or Unsecured

These are two types of loans, and each has different obligations and protections for both borrowers and lenders.

secured loan is a loan that is secured against an asset or assets. Therefore, if the borrower does not pay back their loan, you can take possession of the assets and sell them to hopefully obtain your money back. A secured loan provides you, as a lender, with more certainty that you will receive repayment for the loan, even when the borrower does not pay back the loan. This is, of course, provided that the security is worth enough to repay the loan.

An unsecured loan means that there is no security against the loan if the borrower does not pay back the loan. This means, in practice, that you cannot sell any of the borrower’s assets to recover money if they do not pay you back. Unsecured loans carry more risk as it may be more difficult for you to ensure that you will receive payment for your loan.

Prepayment

You may wish to include a prepayment clause in your loan agreement. This clause provides the borrower with flexibility and allows them to repay the loan early. If the interest rate on the loan is a floating interest rate and you allow the borrower to make prepayments, you might want to only allow the prepayment to occur at the end of an interest period. This will avoid any issues with breakage costs.

You might also require minimum prepayment amounts, or a certain notification period before a prepayment can be made. Here, you can also set out whether any fee is payable for a prepayment.

Repayment

Repayments can be due as a bullet repayment at the end of a fixed period of time. Alternatively, the borrower may need to make regular repayments throughout the term of the loan.

For example, you may require the borrower to pay you back in monthly instalments over a period of five years. 

In some loan agreements, certain events may trigger repayment. However, as a lender, you can also stipulate that repayments are to be made on an on-demand basis.

Events of Default

An event of default is an event where the borrower fails to pay or meet their obligations under the loan. A certain event or situation can trigger it. The definition of a default depends on what the parties agree in the loan agreement. 

It can be based on the type of loan and the relative negotiating power of the parties. This clause stipulates what: 

  • constitutes a default under the loan; and
  • happens in such a situation. 

Some typical events of default include a:

  • failure to pay, where any non-payment of the interest or capital triggers a default;
  • breach of the loan agreement, where any breach of the agreement constitutes a default. For example, this could include non-compliance with an undertaking or a breach of warranty; and
  • insolvency, where the borrower becoming insolvent is a default.

Following the event of a default, you have certain rights under the loan agreement, including if:

  • you have not yet lent the loan amount, you do not need to lend the amount or remaining amount to the borrower;
  • the loan amount has already been lent, you can make any money owed to you immediately due for repayment; or
  • the loan is secured, you may enforce your security over any assets to ensure you receive full repayment.

Undertakings

When loaning money, you may require the borrower to promise to do or not do certain things to best manage and monitor your risk exposure. You may require the borrower to provide you with positive and negative undertakings. 

Positive undertakings are promises to do specific things. They usually relate to the borrower providing information or providing and maintaining security for the loan. 

For example, you may wish to ensure that the borrower’s security assets are insured. This way, you can still recover your money if someone steals the assets.

Negative undertakings are promises not to do specific things. This stops the borrower from taking action that would increase your risk or make it difficult for you to recover your money. 

For example, you may wish to prohibit the borrower from selling assets without your consent or from obtaining another loan until they have repaid your loan.

Key Takeaways

Due diligence and a well-drafted loan agreement are important when loaning money to another business to best manage your risk. It is crucial to seek advice from a legal and financial professional if you are providing a loan. Your loan agreement should include the clauses outlined above to ensure you can enforce the terms of the loan and recover your money. If you need assistance with drafting a business loan agreement, contact LegalVision’s banking and finance lawyers on 1300 544 755 or fill out the form on this page.

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Casey D'Souza
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