Loan contract – important elements

After a Bank (lender) and client (borrower) negotiate a loan they need to formalize business relations. The loan contract is a formal document signed by the borrower while receiving a loan from a financial institution (bank, microcredit institution, etc.). All information, terms, and conditions being agreed to (loan amount, interest rate, terms of loan repaid, etc.) and any negative covenants are incorporated into the loan contract. As a specific legal document that determines the long-term relationship between the lender and the borrower, the borrower should be familiar with important elements of the contract and their implications. Here, we list and briefly describe some of key elements of a loan contract; this is not an exhaustive list and cannot be interpreted as legally binding.

Name and address of contractual parties (i.e. financial institution and client)

"The Borrower" is the person that receives value from the Lender on the condition that the Borrower will pay the principal amount plus any interest to the Lender. "The Lender" is the financial institution (commercial bank, microcredit institution, etc.) that gives money to the Borrower on the condition that the Lender will be paid a certain amount in the future.

The Principal Amount

Principal is an original amount of the loan that is owed by the Borrower (client) to the Lender (bank) on the date the loan contract is signed. Once the Borrower has begun to pay back the loan, principal refers to the amount of money still owed to the Lender.

Total amount repayable

In addition to the specified principal, the loan contract should contain the total amount for repayment (loan value and total cost related to the loan, including interest payments).

The term

Term is the time length of the loan contract. At the end of the term, the full amount of loan must be repaid.

Governing law for a loan contract

Governing law is the law to be used for loan contract enforcement and potential court cases. Clients should be aware of respective laws and respective judiciary institution (court), especially if the bank and the clients' current address, and the given mortgage are not in the same location.

Nominal Interest Rate

Interest is an amount charged to the Borrower for the use of the Lender's money. It is expressed as a percentage of the amount borrowed and is calculated at a specific interval over the course of the term of the loan contract. It can be specified either as fixed interest rate or variable interest rate. For variable interest rates it is important to provide all necessary details on its variability.

Compounding (calculation of interest rate)

There are several methods (conformal method, proportional method and others) and frequencies for calculating interest rates. The more frequently the interest rate is calculated, the more the Borrower will end up paying to the lender. The Borrower should carefully study the applied method of compounding and understand how it will impact the debt service.

Penalty rates

Banks normally charge additional fees for late debt service. The loan contract should contain details about such charges expressed as a percentage and the rules for its later adjustments and any other fees, if applicable, for late payments.

Unilateral changes of contract

Banks may confine the right to make certain changes in loan conditions irrespective of the client. If these conditions exist in the loan agreement the loan contract should specify which conditions and under what circumstances they can be changed.

Collateral for the loan

Loans are very often secured with different instruments (especially, long-term mortgage loans). The loan contract should contain details about instruments which are used as collateral, and sequence and ways for their execution.

Earlier repayment

Borrowers are sometimes interested in earlier loan repayment, in other words, reduction of principal. The Borrower should analyse if the loan contract envisages such a possibility, necessary conditions, and any related consequences (recalculation of interest rates for shorter repayment period, additional fees for earlier repayment, etc.).

Grace period

A grace period is the period when the money is available to the Borrower, but repayment has not yet begun. It is important for the Borrower to specify if interest is charged during the grace period.

Effective interest rate

The effective interest rate reflects the full cost associated with the loan and should be clearly stated in the loan contract. It enables direct comparisons with other loan products and helps clients to understand how much has to be paid for the loan.

Loans with down-payment or deposits

Banks may offer loans with the same nominal interest rate and term, but includes a down-payment or deposit. If the loan is combined with a down-payment, the principal is equal to the loan value reduced by the down-payment and, therefore, annuity is lower. For a loan secured with a deposit (Lombard loan), the principal is equal to the loan value, but the interest rate is lower (the interest rate is the difference between the interest rate for the loan minus the interest rate on the deposit). The deposit can only be withdrawn after the loan is fully repaid.

Loans in foreign currency or indexed to a foreign currency

If loans are in different currencies or indexed to different currencies, then the loan contract should be very specific about foreign exchange rates. Repayment of such loans is directly dependent on changes to the foreign exchange rate for the given currency. Therefore, it should be clearly defined by what type (buying or selling) of exchange rate that will be used for the calculation, the source of information (e.g. Commercial bank exchange rate list, Central Bank exchange rate list or else), as well as precise date of calculation (e.g. end of month, some particular date within the month etc.).

Copies for client

All loan contracts need to be signed, at least, in two copies and the borrower should get one of them.

Instalment