Before You Sign a Loan Agreement…

Understand All of the Terms & Conditions

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If you’ve ever applied for a loan and been baffled by the papers you had to sign, you’re not alone. Those documents were created by lawyers working for big banks and lenders, and they’re stuffed with confusing, unfamiliar language – especially if you’re a first-time borrower.

These contracts spell out exactly what you and your lender have agreed to, including:

  • Your rights and responsibilities
  • The lender’s rights and responsibilities (which vary depending on the type of loan)
  • What happens if either of you don’t fulfill your obligations
  • How disputes will be settled

Loans affect your current and future finances, so it’s really important to read and understand every word before you sign anything. I know they’re long and frustrating – kind of like the user agreements that we all just scroll to the bottom of.

But take the time, ask questions, and make sure you 100% know what you’re agreeing to.

Because once you sign the contract, you’re legally responsible for everything it includes, even if you didn’t realize it.

How Loans Work: The Basics

When you borrow money, you make a commitment to pay that money back plus some extra (interest).The loan officially starts when you sign your agreement and get the money.

Most loans are installment loans, where you borrow a set amount of money for a specific time period (usually 3 to 30 years). You make equal payments over the life of the loan until you’ve paid back the full amount you borrowed. The first payment usually starts about a month after you get the money. You’ll usually have a few options for making your payments:

  • Mailing a check or money order
  • Paying through online banking
  • Setting up automatic payments (where the lender takes the money out of your bank account every month)

Some – but not most – lenders may also allow you to make loan payments with a credit card. But then you’re just really swapping one loan for another, not paying down your debt.

Credit cards count as revolving loans, where you can borrow the same money over and over as long as you make regular payments.

As you make payments, you’ll see your loan balance decrease. In the beginning, a bigger portion of your payment will go toward interest – so it may seem like you’re not making a lot of pay-down progress. But with every new payment, the interest portion will decrease so more of your money will go toward the pay-off.

Different Kinds of Loan Agreements

Loan contracts can be super simple or mind-numbingly complicated. What your agreement looks like depends on who you’re borrowing money from (or lending money to). And they can range from quick and easy to “need a drink to get through this.” You can see samples of some basic different loan agreements here.

A really simple agreement can be just a few words that describe the agreement between the borrower and the lender. For example, “Mac owes Jenny $50” written on a napkin and signed by both of you – that counts as a loan agreement. That kind of contract is called a promissory note, and it basically serves as proof that one person owes money to someone else. This is what you’d use if you loaned money to a friend or family member and wanted some kind of agreement in place (which is definitely a good idea).

Most loans involve more specifics than that, and usually come with phrases like:

  • In exchange for a loan received, I, Mac (“the borrower”), promise to pay $1,000 plus interest to Jenny (“the lender”). This describes the original amount borrowed, also called the principal, and names the borrower and lender.
  • Interest will be charged an annual rate of 3.50% on the entire unpaid balance of the loan until the loan has been paid in full. This spells out the interest rate for the loan.
  • Payments will be made monthly in the amount of $43.20 beginning on September 1, 2020. Each payment will consist of principal and interest. This describes how and when payments will be made.
  • The maturity date of the loan will be August 1, 2022, by which time the loan must be paid in full. This specifies the final due date of the loan.

When you borrow money from a big company – like a bank or a mortgage lender – the agreement will be much more involved. The most complicated contracts can be as fat as notebooks, with dozens of pages devoted to each feature of the loan. These are the ones you really need to slog through, especially if you’re unfamiliar with the lender or the loan involves collateral (property of yours that the lender can take if you don’t pay).

You’ve Gotta Understand the Terms and Conditions

Standard loan agreements use a lot of financial and legal terms, and that combo can be confusing when you don’t speak the language fluently. Even some terms that sound familiar (like interest and principal) can come with unexpected twists in a loan contract. Lenders throw these terms around during the process and expect you to understand them.

So here’s your guide to some common loan language that you need to know:

  • Original loan balance: the total dollar amount you borrowed, also called principal
  • Outstanding balance: the amount of principal you currently owe after subtracting the principal portion of the payments you’ve made
  • Interest: the price you pay for borrowing money, usually expressed as an annual percentage of your current outstanding loan balance
  • Loan term: the amount of time that the loan will be outstanding if you make all of your payments on time
  • Payment: the amount of money you’ll pay the borrower regularly (usually monthly), calculated based on your loan balance, interest rate, and loan term
  • APR (annual percentage rate): the total charges you would pay (interest and fees) if you borrowed the full loan balance for a whole year (meaning you didn’t make any payments during the year), mainly used for comparing different loans
  • Negative amortization: unpaid interest that gets added to your outstanding balance, increasing the amount you owe, which only happens if the payment you make doesn’t cover the full amount of interest due that month
  • ACH payments: letting your lender pull your monthly payments directly from your bank account, usually in exchange for a reduced interest rate
  • Collateral: property of yours that the lender can take and sell if you don’t pay the money back as promised
  • Mandatory arbitration: this forces you to resolve any disputes privately through an arbitrator (a professional conflict decider) rather than through the court system, and whatever the arbitrator decides is final
  • Cosigner: a person who promises to pay the loan for you if you don’t make your required payments, sometimes required if you don’t have good credit or a long enough credit history
  • Closing: the meeting – in person or virtual – where money (and possibly property) legally changes hands
  • Prepayment penalties: fees charged by the lender if you pay off your debt too quickly
  • Delinquency: missing a single payment due date
  • Default: not making a specific number (varies by lender but usually 3) of consecutive payments, which can lead to serious financial consequences like getting sued or having collateral repossessed

APR and interest rate seem like the same thing, but they’re not. APR includes the total borrowing costs—interest and fees—that you’d pay over one year on the original loan amount, expressed as an annual percentage. Interest rate includes only that, the percentage you’ll pay periodically based on the outstanding loan balance.

You may come across other unfamiliar words (or words that don’t mean quite what you thought they did) in your loan agreements. Before you sign, ask the lender to explain them to you so you know exactly what you’re agreeing to. If you they brush you off or don’t answer in a way that makes sense to you, ask again or ask someone else (feel free to contact me with questions).

Want to learn more about loans and how you can use them to your advantage? Check out my book Debt 101.

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