Introduction
With the high competition in the MSME business industry, most companies require loans to compete and expand their businesses, where the business loan will be used for operations, business expansion, and meeting working capital by the MSME owners. However, terms that an applicant will encounter with regard to a loan agreement are many, and sometimes confusing if the business owner does not understand financial words.
A business loan agreement is a form of legal document that explains the conditions under which the loan is allowed. A business loan agreement basically contains essential facts like the loan amount, interest rate, repayment schedule, and other terms and conditions. Once you get the main terms of a loan agreement, you may avoid various future complications and make your business run smoothly.
This article will provide you with an explanation of some of the key terms involved when reviewing a business loan agreement so you understand them better. This will better equip and help you to walk through this process with more confidence and avoid misunderstandings.
Understanding Core terms to understand in loan agreement
Principal Amount: It is the total sum of the borrowed amount by you from the lender. It includes the actual loan amount minus interest and other charges.
For example, suppose you take a collateral free business loan of ₹5,00,000. So The ₹5,00,000 is your principal amount without including Interest rate charges, processing fees, etc.
Interest Rate: The interest rate is the percentage charged by the lender on the borrowed amount. Business loans may either have a fixed interest rate or a floating interest rate:
- A fixed interest rate will not vary within the loan period; hence, your monthly payments will be constant, and you can easily plan for it.
- The other is a floating rate; this floats according to the market and can go up or down. Your payment may increase or decrease further depending on the changes in the rate.
Tenure or Loan Term: Tenure or loan term is the duration within which you are required to pay back the loan. This can range from several months up to some years, depending on the specific loan type. The shorter the loan tenure, then all the more frequent but smaller payments are added as less interest is incurred. But the more extended tenure goes with much smaller monthly payments but for a significantly larger total interest.
Repayment Schedule: The repayment schedule indicates how and when you have to refund the loan. Most unsecured business loan repayments are through installments, normally every month which is popularly known as EMI (Equated Monthly Installments). The schedule will indicate the amount of the individual payment and the date on which the payments are due. This means that one has to follow the schedule strictly to avoid late fees and penalties.
Collateral: Collateral is an asset to be pledged to the lender as security for the loan. In case you are not able to pay the loan amount back, or in other words, default on the loan, then the lender will make use of the collateral taken as a guarantee to recover the amount lent. General kinds of collateral are property, equipment, inventory, or any other kind of valuable thing. Most loans are unsecured loans, meaning that they do not involve collateral, but these attract higher interest rates because, by taking this type of loan, the lender is at a higher risk.
Default: Default will occur in case the borrower fails to carry out the obligations in the loan. This may comprise missing a pay, not providing some required documents, and other terms the borrower fails to comply with. In case you default on a loan, the lender may take some legal action, or simply repossess the collateral depending on the terms of the agreement. Be careful and read carefully the conditions that may lead one to default so that one can prevent yourself as a business owner from such incidences.
Prepayment Clause: A prepayment clause must clarify whether you are permitted to repay the loan before the agreed loan term expires. If so, whether you must incur penalties and charges with respect to such repayment. This is because, under certain prepayment charges, some lenders will charge an amount of penalty if the borrower chooses early loan repayment by utilizing the future date interest amount. It is highly recommended that before you go for the shortening of the loan term, first understand these charges.
Processing Fees and Other Charges: There are few financial institutions that charge a processing fee before approving and disbursing the loan. This is usually a small percentage of the loan amount to process your business loan application. Except for the processing fee, other fees that may be charged by the lender include documentation fees, late payment charges, or foreclosure charges. Such additional costs must be added to your calculation of the total cost of the loan.
Covenants: Loan agreements normally contain covenants. A covenant refers to an agreement or condition that the borrower commits to, and needs to follow through. A covenant could either be a financial one, such as a requirement that a certain minimum debt-to-equity ratio be maintained, or it could be of a non-financial nature, such as submitting regular statements of financial conditions to the lender.
Grace Period: A grace period is the time between when the loan falls due and some time ahead of that date; you can make a payment without attracting a fee for being late. For example, suppose you need to pay on the 1st day of the month, but a lender allows a grace period of 5 days. In such a case, you can pay before the 5th day of the month without attracting fees.
Conclusion
The above are the most crucial key terms of a business loan and are something a business owner has to be aware of to borrow funds. Knowing what principal and interest rate, and all the other terms that have been used, will enable you to make better decisions and stay away from potential risks. Always review carefully before signing the loan agreement. Clarify all your questions with your lender, and do not hesitate to ask for help if more guidance is required. This enables you to have a clear understanding of the loan agreement; easy financial management in your business; and gives you a good relationship with your lender, too.
Many of the business owners go for NBFCs for their funding needs. The business loans offered by the NBFCs are fast, flexible, and accessible with lesser amount of difficulty or hassle as compared to the traditional banks. They have customized loan products, highly competitive interest rates, and faster disbursal of loans.