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Updated on Monday, August 12, 2019
If you’re taking out any kind of loan, you should be familiar with the contract that will dictate the terms of that loan. Your loan agreement will tell you about responsibilities and expectations on both the lender side and the borrower side. Here we will focus mainly on agreements for personal loans.
What is a personal loan agreement?
When taking out any kind of loan, including a personal loan, you’ll have to sign a loan agreement in order for a loan company to disburse the funds to you. This agreement may also be called a promissory note.
The loan agreement is a legal contract that specifies the responsibilities and expectations of both the lender and borrower in the transaction. It’s important to understand the terms and conditions of the loan in order to avoid getting into a precarious financial situation after taking it out.
The importance of these agreements is that they will also be a guide in the case of a breach or violation on either side, said Brian Locker, partner at Fowler St. Clair in Mesa, Ariz. Locker practices civil litigation and regularly represents consumers with claims against lenders and businesses.
“In the event of any conflict between you and the lender during the term of the loan, the resolution will almost certainly be dictated by the terms of that agreement,” Locker said.
For example, there may be steep penalties for missing payments or provisions in an agreement that allow the lender to sue you in court and require you to pay the legal fees in case of default.
These are very serious repercussions, so it’s best to know if you are exposing yourself to these risks before signing your name on the dotted line.
What is a personal loan?
Before signing a loan agreement, you should have full knowledge of the kind of loan you are taking out. One such loan may be a personal loan.
You can get a personal loan from a bank, credit union or online lender. Personal loans can be used for a variety of purposes such as consolidating debt, renovating a home or covering emergency expenses. Some personal loans have stipulations (usually stated in the agreement) on what you can and cannot use the money for.
These types of personal loans are generally unsecured loans. Unlike a home loan or auto loan, these loans are not secured by any type of collateral. These loans are also different from credit cards because you receive a lump sum of borrowed money upfront, and there is a fixed amount of time in which the loan has to be paid off. When dealing with a bank or finance company for a personal loan, you must sign a loan agreement before you receive the money you’re borrowing.
“Personal loan” may also refer to borrowing money from a private party, such as a loan between family members or friends.
How can I get a personal loan?
As mentioned, unsecured personal loans are usually not backed by an asset, meaning the lender may not seize an asset and sell it to recoup the loan amount if you fail to repay it. If you don’t pay back the loan in this case, the lender could lose the money it provided.
To mitigate this risk, personal loan lenders often set strict borrower criteria and qualifications for unsecured loans. Personal loan companies will look closely at your credit score, existing debt obligations and income history during the application process.
Some lenders will allow you to see loan rates you might qualify for by doing a soft pull on your credit report (soft pulls don’t affect your credit). Other lenders may generate a hard inquiry record on your credit report, which could negatively affect your credit score. Make sure you know whether the lender is conducting a soft or hard pull on your credit before you request a rate quote.
Why do you need a loan agreement?
Though the general public can be distrusting of lenders and especially wary of the contracts they’ll sign to borrow money, rest assured that your loan agreement can actually give you rights in the lending process as well.
Rebecca Neale of the Personal Finance Lawyer is a family law attorney whose work often intersects with consumer law issues.
“Just because a loan contract specifies what happens in case of default doesn’t mean that the lender expects you to default,” said Neale. “The purpose is to inform both parties of their responsibilities and liabilities in case of default.”
Loan agreements, in part, make sure banks can lend money affordably. To do so, they must manage the risk of default by giving borrowers clear, consistent terms for repayment.
Loan agreements should also be in place when lending money to friends and family. You may think a formal document isn’t needed for a transaction with loved ones, but the IRS has restrictions on money flowing between individuals. According to the gift tax, individuals are allowed to give up to $15,000 to any one person before tax implications kick in (this means married couples can give up to $30,000).
Your loan agreement for private-party loans will prove to the IRS that the money is not a gift and therefore not subject to the gift tax (which the giver usually pays). Plus, a loan agreement with clear terms and repayment guidelines can help save personal relationships that could otherwise be ruined by money misunderstandings.
These personal loan agreements between private parties are not hard to find. You can do a quick search online for “personal loan agreement templates,” or ask an attorney to draw one up for you. The cost may be well worth it to have a clear understanding of each person’s responsibility in a personal loan situation.
What is contained in a loan agreement?
When it comes to dealing with commercial entities such as banks or financial companies, most lenders have a standard personal loan agreement that serves as a binding contract for borrowers.
Here are the standard sections and items you’ll see in your personal loan agreement:
Principal loan amount
This is how much money you are borrowing. Personal loans typically range from $5,000 to $100,000.
Borrower, cosigner and lender information
This will contain personal identification information for borrowers, such as name and address. The lender’s information will also be in the contract.
Interest amount, calculation method and rate type
There are many combinations of interest types and rates possible for personal loans. Most personal loans are amortizing, which means payments are equally spaced with a simple (not compound) interest rate. This rate is often expressed as an annual percentage rate (APR). But there are other options and terms you should know about when it comes to these loan variations:
- Compound interest: Interest charged on a total outstanding loan balance, including the principal and previously accrued interest.
- Simple interest: Interest charged on a principal balance that is not then added to the principal balance.
- Variable interest rate: An interest rate that changes over time, often based on prevailing market interest rates.
- Fixed interest rate: An interest rate that does not change over time.
- APR: The cost of borrowing money over the course of a year, including interest and fees, expressed as an interest rate.
- Interest rate: The cost of borrowing money, expressed as a percentage of the loan amount.
If you are unsure of how the terms will affect your monthly payment, check the Truth in Lending Disclosure for your loan, which will give you a summary of your loan agreement for review purposes. It’s usually given to you by the lender before you officially accept the loan by signing the agreement. This disclosure is not your loan agreement but is useful for knowing upfront the costs of borrowing money before entering into the loan contract.
Date of loan transaction
This serves as the first date of your loan term.
Loan repayment term length
The term is how long you will take to pay the loan back. Terms for personal loans vary and are often between six and 84 months.
Loan payment method and due date
This section informs you of where to send your payment and the date it is due each month. If you don’t send your payment in accordance with the contract, your payment could be considered late or missed. Furthermore, changing repayment methods could increase your initial APR (e.g., paying with a check versus automatic [ACH] withdrawal.)
Return payment fees
If for some reason your payment is returned, this is the fee you will be charged.
Some lenders charge fees to process a loan application. This can be expressed as a flat fee or a percentage of your loan amount. The origination fee is often deducted from your initial loan disbursement from the lender.
Prepayment fees and penalties
You may be subject to penalties or fees for paying off a loan before the term is over.
Application of payment
This explains how your payments are applied and in what order they are applied to the principal, fees, interest, etc.
Penalties for missed and/or late payments
This section will tell you what exactly constitutes a late or missed payment.
State law notices
Contains special notices and legal provisions for residents of certain states.
What happens if the loan contract is violated?
A loan contract can be violated in a number of ways. On the borrower side, a violation may occur when a lender determines the borrower is in default. Default can happen for a variety of reasons, from missing payments to misusing loan funds.
In this case, the lender can demand funds be repaid in full. In addition, the borrower may have to agree to pay all costs of collecting delinquent payments and reasonable attorneys’ fees.
J.R. Skrabanek is a consumer law attorney and senior counsel at The Snell Law Firm, in Texas. He said that, when consumers violate a loan contract, there may be recourse if they actually show up in court. “In general, courts may be more willing to forgive unsophisticated consumers for mistaken contract violations than large companies,” he said. “However, contracts are usually enforced as written, and you very often have to go to court to enforce your rights.”
On the lender side, it’s rare that loan agreements are violated. However, lenders that engage in predatory lending practices or illegal debt collection practices could be violating state and federal laws that expressly forbid these kinds of activities. Skrabanek said such things may not violate the loan contract but may be punishable under regulations such as the Fair Debt Collection Practices Act.
Common legal terms
- Usury and predatory protections: Laws that protect consumers from illegal and harmful lending practices.
- Mandatory arbitration: A clause that requires borrowers to agree to an arbitration process to settle disputes over a loan agreement.
- Breach or default: Failure to fulfill a contract obligation.
- Contract length and amortization: Defines the loan term and whether or not loan payments are fully or partially amortized over that term.
- Choice of law: States the jurisdiction under which the provisions of the loan agreement will be governed.
- Severability clause: States that if some parts of the loan agreement are found to be illegal or otherwise unenforceable, the remaining provisions are still valid and enforceable.
- Entire agreement clause: States that the loan agreement presented is complete.
- Default provisions: Defines criteria that constitute a default event for borrowers.
- Loan security: The collateral (some type of asset) pledged for a loan.
A personal loan agreement exists to protect both you and the lender. Before you take out a loan, make sure you have a full understanding of what this agreement entails, and what all the terms involved mean.