Why should I create a loan agreement?

A loan agreement is important whenever a person or business is borrowing money from another person or business. The agreement spells out the amount borrowed and the terms for repaying the loan. In the event the borrower does not uphold its end of the agreement, valid loan agreements can be enforced. This protects the lender. However, loan agreements can also protect the borrower by making the terms clear. For example, a lender that tries to charge more interest or accelerate repayment in violation of what the loan allows could be forced by the court system to stick to the agreement’s original terms. Finally, loan agreements also provide evidence that the money the borrower received was in fact a loan and not a gift.

What is the difference between compound and simple interest?

When it comes to the amount of interest on a loan, the loan agreement should spell out whether the interest is simple or compound. Simple Interest Agreements that use a simple interest formula multiply the interest rate by the principal amount of the loan to calculate the fixed amount of interest to be paid along with the principal amount borrowed. Simple interest is only calculated on the principal amount of the loan. For example, a $10,000 loan with a 7% simple interest rate would require the borrower to pay $700 in interest ($10,000 x .07 = $700). If the loan is going to be repaid over a period of three years, you will need to multiply the amount of simple interest by three, giving you a total of $2,100 in interest to pay. In summary, the borrower would be getting $10,000 up front and would have to agree to repay a total of $12,100 over the three years ($10,000 + $2,100). Compound Interest With a compound interest calculation, the compound interest accrues on the amount of the unpaid loan principal and accumulated interest from previous periods. So, when a borrower agrees to compound interest, they are in effect paying interest on the interest. Generally speaking, the borrower will pay more over the life of the loan to borrow money under a compound interest loan than they would for a simple interest loan.

What is collateral and should I include it in my loan agreement?

If a loan agreement includes collateral, it means that the borrower has agreed to pledge certain assets as security for the loan. In the event the borrower defaults and does not uphold his or her agreement to repay the loan amount plus interest, the lender gets to keep the pledged collateral. Loans that use collateral are often referred to as “secured loans.” In theory, almost any asset can be used as collateral. However, in practice, most lenders will only want collateral that they could actually use or sell in the event the borrower defaulted on the loan. When you buy a home, your house is the collateral for a home mortgage. Similarly, auto loans are secured by the vehicle itself. Personal loans may be secured by stocks or bonds, bank accounts, insurance policies, machines or equipment, collectibles, or by other financial asset(s). Generally speaking, pledging collateral for a loan can be advantageous to the borrower because the lender may be willing to offer a lower interest rate or loan a larger dollar amount. The lender’s risk of loss is lower because it knows it can claim and sell the borrower’s collateral in order to prevent or diminish its losses in the event of a default. Borrowers should make sure they will be able to adhere to the terms of the loan agreement so they do not risk losing their pledged assets.

What is the difference between fixed and variable rates of interest?

Loan agreements should specify whether the interest rate the borrower is agreeing to is fixed or variable. When a loan agreement uses a fixed interest rate, the interest rate will not go up or down over the life of the loan. This allows for a defined, fixed payment schedule and can be attractive to borrowers who want to know that their monthly payments will be fixed. In contrast, when a loan agreement uses a variable interest rate, that rate will likely change during the term of the loan. When loans are based on variable interest rates, those rates are generally tied to either the prime lending rate or an index. Variable rate loans can be advantageous for borrowers when interest rates go down. However, if the rate rises, the borrower will still need to be able to make his or her payments under the agreement.

Are there different types of loan agreements?

Yes. Loan agreements can range from simple promissory notes to complex loans like mortgages and auto loan agreements. Loan agreements are governed by state and federal laws, which provide limits on the amount of interest lenders can charge when loaning money. Those laws also provide a framework and guardrails for other terms and conditions of loan agreements, designed to protect both the lender and the borrower in the event the agreement is later taken to court.

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When you should use a loan agreement

You need to formalize all loan-related details
Money or property is being loaned to one or more borrowers
You need to define a loan's payment frequency and interest, among other options
You need an agreement that protects the lender and defines repayment terms

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