Loan Agreement – What it is and How it Works

A loan agreement is a legal document that specifies crucial counterparty details and obligations together with credit conditions, including loan amount, types, payback duration, and interest rate. Additionally, it is drafted by the lender’s legal team to guarantee the contract’s legal enforceability. It is made between the creditor (the lender) and the borrower (the debtor).

Loan Agreement - What it is and How it Works

Generally, a loan agreement can be referred to as various things, like a credit agreement, a financing agreement, or, in some situations, a pledge note. Loan agreements can range from simple letters outlining the borrower’s obligations, such as repayment dates and interest rates, to complex mortgage agreements that consider the loan purpose and borrowed amount. However, federal and state regulations apply to all loan agreements, regardless of kind, to guarantee that the agreed-upon interest rates are both reasonable and lawful.

How Does a Loan Agreement Work?

An agreement about a loan serves the function of outlining the obligations, liabilities, and duration of the parties concerned. A loan agreement should adhere to state and federal standards to protect both the lender and the borrower from potential breaches.

Depending on the type of loan, different conditions will apply to the terms of the contract. This includes which state or federal laws apply to the performance duties that both parties must fulfill. Additionally, the majority of loan agreements specify exactly how the funds are to be used.

Laws do not distinguish between loans for new cars or homes, between debt repayment plans for new and old debt, or between conditions that are merging or not. The loan contract, signed by both the borrower and lender, serves as a legally binding agreement on the use of funds, repayment terms, and amortization rates. The funds should be returned to the lender right away if they are not used for the intended purpose.

Why is a Loan Agreement Important?

When one party obtains assets from another in return for future payments, credit is established. Additionally, when credit is established, both counterparties consent to a set of duties and obligations toward one another. The lender is obligated to ensure the borrower’s access to funds at the agreed time and date, excluding default scenarios.

Along with adhering to specific practices, the debtor (borrower) also promises to pay interest and/or principal on time and to submit any necessary financial reports to the lender. However, if any party fails to fulfill their duties, the other party cannot seek legal redress without a written loan agreement binding them both.

Why You Need a Loan Agreement

To safeguard both parties, a loan agreement must be in place before making a financial loan or rendering services without receiving payment. A loan agreement certifies that the loan was not given as a gift and provides information on the loan amount, terms of repayment, and expectations.

Additionally, it can avoid problems with the IRS and stop illegal claims. Having a loan agreement with friends or family is beneficial to prevent disputes and maintain a strong connection, even if you don’t believe it’s necessary.

For loans beyond a certain amount, drafting a loan agreement is necessary and well worth the additional work. It is broken up into sections for easy reading and has many components to make it enforceable.

When You Can Use a Loan Agreement

Generally, loan agreements are advantageous whenever funds are borrowed since they formalize the procedure and yield outcomes that are often more advantageous for all parties. While loan agreements are useful in all lending situations, they are most frequently employed in loans that are repaid gradually, such as:

  • Private or individual loans made to friends or relatives;
  • The funding of major purchases, such as cars or furnishings;
  • Loans for students.
  • Loans for business or commerce, such as startup capital loans;
  • Mortgages and other real estate loans.

What Should a Loan Agreement Include?

In its most basic form, a well-drafted loan agreement may be thought of as your future insurance policy. Moreover, when someone defaults, a loan agreement must be in place. Although the specifics of loans vary based on their intended use, all loan agreements have certain essential terms.

These comprise the borrower’s identity and contact details, the lender’s details, the transaction’s particulars (amount, length, interest rate, etc.), the terms of repayment, the penalties for making late or late payments, and, if applicable, any collateral needs. A few details seen in loan agreements are:

Interest rate

The kind of loan, the borrower’s credit score, and the loan security all affect interest rates. The loan document specifies the terms of the loan, whether they are set or flexible. However, only sophisticated loans, such as adjustable-rate house mortgages, employ floating fee rates that vary periodically and generally.

Contract duration and amortization

Using an amortization schedule, the lender divides the total number of installments and adds interest to determine monthly payments. The cost of the mortgage increases with the length of the payment period. Moreover, early repayment is typical, and costs decrease with the speed at which the loan obligation is paid off.

Pre-payment fees and penalties

Prepayment penalties are common in loans, especially subprime mortgages and car loans, and they may have a big effect on refinancing expenses. The penalties, typically 2% of the owed amount, can be applied to government-backed FHA loans without a due-on-sale condition, aiming to benefit the poor. The cost of refinancing a loan may increase dramatically as a result of these penalties.

Breach or Default

If a borrower has missed payments or made late repayments, the loan is deemed to be in default. The lender has the right to file a lawsuit, collect expenses and liquidated damages from the borrower, seize assets, and harm the borrower’s credit history.

Mandatory arbitration

More than half of lending institutions employ mandatory arbitration as a substitute for going to court to resolve disputes more quickly and affordably. Since arbitration lacks appeals, specialist legal representation, and consideration for the Fair Credit Reporting Act and Truth in Lending Act, it frequently benefits lenders. Serving overseas, military members are more susceptible to arbitration, which might result in the loss of their cars.

How to Write a Loan Agreement

Through online legal information pages and software providers like Adobe, Microsoft, and Google, loan agreements may be created quickly and easily thanks to the internet. Before signing, all parties must go over and accept the conditions; a template can serve as a legally binding contract.

Writing a legally binding loan contract involves the following steps:

  • The loan’s effective date.
  • Which state’s lending regulations (if the borrower and lender are in different states) will be in effect?
  • Complete details on the lender and borrower, including complete legal names, phone numbers, addresses, and social security numbers.
  • Loan total, including the loan’s principle. Interest and other costs are not included.
  • Interest rate. If interest is charged, it must be made clear what the percentage is and how often it will be charged.
  • Will it be paid all at once on a predetermined date, or just when needed? Are payments made every month or on another consistent basis? If yes, how much will you be paying?


  • Late costs. If late payments are going to incur fees, the amount and minimum quantity of late payments required must be stated.
  • Collateral, if any. The loan agreement must state whether or not the loan will be secured by real estate. The specifics have to be as precise as possible.
  • Early or prepayment of money. Indicate if early repayment of the loan is permitted and whether there will be consequences for doing so.
  • The number of missed payments required before the loan enters default and the consequences after that must be agreed upon by both parties.
  • Co-signer, if relevant. A cosigner, or technically, a guarantor, may be required by the lender to guarantee loan repayment. The cosigner is required to cover the remaining amount in case the borrower defaults.

Along with the borrower, the co-signer will sign the loan. However, they should read the document carefully before signing. Although it’s not required, a loan agreement may have a box to indicate whether or not there is a co-signer.


Does a loan agreement need to be witnessed?

To reduce the chance of disagreements, it is best to complete a loan agreement in front of a third party, preferably someone who is sober and not under the influence of drugs or alcohol and who is over the age of 18.

Is a loan agreement a contract?

Yes, it’s a legal agreement between two or more people to formally establish a loan and repayment mechanism.

Why Do You Need a Loan Agreement?

The reason you need a loan agreement is because each party’s rights and intentions are documented in it. When a disagreement occurs, it is a tangible piece of evidence that can be swiftly evaluated to determine how the parties should behave.