Loan Agreement: Purpose & Interest Rates

Few people get by in life without borrowing. Almost everyone, with a few exceptions, takes out a loan to buy a car, finance a home purchase, pay for a college education, or cover a medical emergency. Loans are almost universal, as are the agreements that guarantee their repayment.

Borrowing agreements are legally binding contracts entered into by two or more parties to formalize the loan procedure. Loan agreements can range from basic promissory notes between friends and family to more comprehensive contracts such as mortgages, auto loans, credit cards, and short- or long-term payday advance loans.

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A Loan Agreement's Purpose

A loan contract's major purpose is to define what the parties are agreeing to, what responsibilities each party has, and how long the agreement will endure. A loan agreement should be in accordance with state and federal standards in order to protect both the lender and the borrower if any party fails to follow the agreement. Depending on the loan type, the loan contract terms and which state or federal laws control the performance requirements needed of both parties will differ.

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Other Goals of a Loan Agreement

1. The main objective of a loan contract is to describe what the parties are committing to, what responsibilities each party has, and how long the agreement will last.

2. A loan agreement should be written in accordance with state and federal guidelines to protect both the lender and the borrower if either party fails to follow the terms of the agreement.

3. The performance criteria required of both parties will vary depending on the loan type, loan contract terms, and which state or federal laws govern.

4. If the loan contains interest, one party may want to add an amortization chart that explains how the loan will be paid off over time and how much interest is included in each payment.

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Determination of Interest Rates

Many consumers who are getting their first loan for a new home, car, or credit card are unfamiliar with loan interest rates and how they are calculated. The interest rate is determined by the loan type, the borrower's credit score, and whether the loan is secured or unsecured.

A lender may request that the loan interest be attached to tangible assets such as a car title or a property deed in specific situations. State and federal consumer protection regulations establish legal limits on the amount of interest that a lender can legitimately charge without it being considered illegal and excessive usury.

If the loan includes interest payments, which the majority do, the details will be outlined in the loan's terms and conditions. Interest is either fixed or variable.

A fixed fee, or fixed rate, loan has an interest rate that remains constant during the loan's repayment. As the sum is worked down, the amount of interest paid decreases while the principal payment increases.

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Amortization and Contract Length

A lender's dependence on an amortization schedule determines the length of a loan contract. Once the lender and the borrower have calculated the amount of money required, the lender will use the amortization table to calculate the monthly payment by dividing the number of payments to be made by the number of payments to be made and adding the interest to the monthly payment.

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Penalties and Pre-Payment Fees

While paying back a loan as soon as possible is a financially sensible practice, there are some loans that penalize the borrower with pre-paid fees and penalties for doing so. Prepayment penalties are common in auto loans and subprime mortgage loans. They can also occur when borrowers refinance a home or auto loan.

Prepayment penalties are imposed to safeguard the lender, who expects a specific return on his loan over a specific time period. For example, if a borrower repays a five-year loan in three years, the lender is out the interest he planned to pay for the latter two years of the loan.

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Default or Breach

A loan contract is regarded in default if it is not paid off on time. To compensate the lender for any losses, the borrower may be liable for a wide range of potential legal damages.

The breached or defaulted lender may seek legal action and have the borrower held accountable for legal fees, liquidated damages, and even have assets and property attached or auctioned to settle the debt. A breach or default of a court decision can also be recorded on the borrower's credit record.

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Promissory Notes

Promissory notes are similar to loan arrangements but less complex. They are frequently little more than commitment-to-pay letters, similar to IOUs, or simple payment on demand notes. Typically, the borrower produces a letter outlining the amount of money borrowed and the terms under which it will be repaid. They are almost always used for minor loans between people who are well acquainted.

Promissory notes are legal documents that are signed and dated. Secured and unsecured promissory notes are both possible. Secured loans provide collateral to the lender if the loan is not repaid, whereas unsecured loans do not. They may or may not include stipulations relating to installment payments and interest.

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