A Quick Guide to Commonly-Used Loan Terms

If you are new to lending transactions, interpreting a term sheet, LOI, or credit memo can feel like reading a foreign language. These documents, dense with financial terminology, outline the obligations and rights of both parties involved in a lending transaction. Understanding the terms and conditions laid out in these agreements is not just about legal compliance; it's about making informed decisions that align with personal or organizational financial goals. This quick guide aims to define and explain some of these complex terms, so that you can be better informed the next time that you sign on the dotted line.

Credit Facility

A credit facility encompasses a suite of financial products offered by lending institutions to provide borrowers with flexible borrowing options. Unlike a simple loan, a credit facility can include various structures such as revolving credit, term loans, and letters of credit, each tailored to different financial needs. Revolving credit facilities, for example, offer a flexible line of credit for operational expenses, while term loans might finance capital expenditures with a fixed repayment schedule. Credit facilities are crucial for businesses seeking adaptable financing solutions to support growth and manage cash flow efficiently.

Example in Loan Agreement: "This Credit Facility Agreement grants the Borrower access to a suite of borrowing options, including a $500,000 Revolving Credit Line for operational liquidity, a $2,000,000 Term Loan for capital expenditures, and up to $500,000 in Letters of Credit for trade financing. Each component of the Facility is governed by specific terms, providing a comprehensive financial toolkit to support the Borrower's diverse needs."

Revolving Credit vs. Term Loans

Revolving credit and term loans represent two fundamental types of financing within a credit facility. Revolving credit offers dynamic access to funds, allowing borrowers to draw down, repay, and redraw funds within a credit limit, making it ideal for managing fluctuating capital needs. In contrast, term loans provide a fixed amount of money upfront, with a predetermined repayment schedule, suitable for financing specific projects or purchases. The choice between revolving credit and term loans depends on the borrower's financial strategy and the predictability of their capital requirements.

Example in Loan Agreement: "The Borrower may utilize the Revolving Credit Line for ongoing operational expenses, drawing and repaying funds as needed, with interest accruing only on the utilized portion. The Term Loan, however, disburses a fixed amount for the purchase of a new manufacturing facility, with a structured repayment plan over ten years, reflecting the long-term investment nature of the expenditure."

Interest Rate

The interest rate on a loan determines the cost to the borrower for accessing funds, serving as compensation to the lender for the risk of lending. Interest rates can be fixed, offering stability over the loan term, or variable, fluctuating with market interest rates. The rate reflects various factors, including the borrower's creditworthiness, market conditions, and the loan's duration. Understanding how interest rates are calculated and applied is crucial for borrowers to assess the total cost of borrowing and to compare different loan options effectively.

Example in Loan Agreement: "The interest on the Revolving Credit Line is variable, tied to the prime rate plus a margin of 2%, allowing the interest cost to adjust with market conditions. Conversely, the Term Loan features a fixed interest rate of 5% per annum, providing the borrower with predictable repayment amounts, irrespective of market fluctuations."

Collateral

Collateral refers to assets pledged by the borrower to secure a loan, reducing the lender's risk by providing a recourse in case of default. Collateral can range from real estate and equipment to inventory and receivables, depending on the loan type and purpose. The valuation of collateral is a critical factor in determining the loan amount and terms, with a detailed appraisal process often required to assess the asset's worth. The inclusion of collateral in a loan agreement underscores the seriousness of the borrowing commitment and the mutual interest of both parties in ensuring the loan's successful repayment.

Example in Loan Agreement: "As security for the loan, the Borrower pledges its headquarters building, valued at $1,000,000, as collateral. This pledge grants the Lender a secured interest in the property, ensuring that in the event of default, the Lender may seize and sell the property to recover the outstanding loan balance."

Amortization

Amortization refers to the process of spreading out loan payments over the life of the loan, incorporating both interest and principal repayment in each installment. This structured approach ensures that each payment contributes to reducing the loan balance, leading to full repayment by the end of the term. Amortization schedules can vary, with some loans offering interest-only periods or balloon payments. Understanding the amortization schedule is essential for borrowers to plan their cash flow and budget for loan repayment.

Example in Loan Agreement: "The loan features a 20-year amortization schedule, with monthly payments calculated to evenly distribute the cost of the loan, including interest and principal, over the term. The schedule provides the Borrower with a clear repayment timeline, facilitating long-term financial planning and budgeting."

Covenant

Covenants in a loan agreement are conditions set by the lender to maintain the loan's integrity and the borrower's financial health. These can be affirmative, requiring the borrower to take specific actions, or negative, prohibiting certain activities. Covenants cover a wide range of financial and operational metrics, from maintaining minimum liquidity levels to restricting additional debt. They are designed to protect the lender's interests while encouraging responsible financial management by the borrower.

Example in Loan Agreement: "The loan covenants include a requirement for the Borrower to maintain a minimum liquidity ratio of 1.5 and restrict the incurrence of additional secured debt without the Lender's consent. These covenants ensure that the Borrower remains financially stable and prioritizes the repayment of the loan, protecting the Lender's investment."

Debt Service Coverage Ratio (DSCR)

The Debt Service Coverage Ratio (DSCR) is a financial metric used by lenders to evaluate a borrower's ability to cover loan payments with its operational income. A DSCR greater than 1 indicates that the borrower generates sufficient income to cover its debt obligations, providing a buffer against financial uncertainties. Lenders closely examine DSCR when assessing loan applications, as it offers insight into the borrower's financial health and the loan's risk profile.

Example in Loan Agreement: "The Borrower is required to maintain a DSCR of at least 1.3, calculated by dividing the annual net operating income by the annual debt service obligations. This ratio ensures that the Borrower's income exceeds its debt payments by a comfortable margin, signaling strong financial health and reducing the risk of default."

Loan to Value (LTV)

The Loan to Value (LTV) ratio is a critical measure in secured lending, comparing the loan amount to the appraised value of the collateral. A lower LTV ratio indicates a higher level of security for the lender, as it means the loan amount is well-covered by the collateral's value. LTV is a key factor in loan approval decisions, influencing loan terms and interest rates. Borrowers should be aware of the LTV ratio's impact on their financing options and the importance of accurate collateral valuation.

Expanded Example in Loan Agreement: "The LTV ratio for the property loan shall not exceed 75%, ensuring that the loan amount is conservatively aligned with the property's market value. This LTV threshold protects the Lender by ensuring a significant equity cushion in the collateral, reducing the risk of loss in the event of default and foreclosure."

Owner-Occupied Commercial Real Estate (OOCRE)

Owner-Occupied Commercial Real Estate (OOCRE) refers to properties that are primarily used by the owner for conducting their business operations. This contrasts with investment properties, which owners purchase primarily to generate rental income or for capital appreciation. OOCRE includes buildings and spaces ranging from office buildings and retail shops to industrial warehouses, where the owner's business occupies a significant portion, typically more than 50%, of the property.

Why Lenders Care: Lenders often have a distinct preference or policy when it comes to financing OOCRE due to the unique risks and benefits associated with these properties. On one hand, OOCRE loans might be seen as less risky because the owner's vested interest in the property (as it is critical to their business operations) can lead to better maintenance and management of the property. Additionally, the success of the owner's business directly contributes to the ability to service the loan, providing a dual layer of security for the lender.

On the other hand, the financial health of OOCRE is closely tied to the success of the borrower's business, which can be a double-edged sword. If the business faces financial difficulties, it could impact the property's value and the owner's ability to make loan payments. Therefore, lenders might conduct a more thorough review of the borrower's business plan, financial statements, and the property's suitability for the intended business use before approving a loan for OOCRE.

Example in Loan Agreement: "The Borrower hereby declares that the commercial property located at 123 Business Lane, which is the subject of this loan, will be used as the primary operating facility for XYZ Manufacturing, Inc., constituting more than 60% of the total usable space of the property, thereby designating it as Owner-Occupied Commercial Real Estate (OOCRE) under the terms of this Agreement. The Lender has considered the dual use of the property—as both the collateral and the primary business location of the Borrower—in the underwriting process and loan terms."

Personal Financial Statement (PFS)

A Personal Financial Statement (PFS) is a document or spreadsheet that outlines an individual's financial status at a specific point in time. It details the individual's assets (what they own), liabilities (what they owe), and calculates the net worth by subtracting liabilities from assets. Additionally, a PFS often includes information about personal income and expenses, providing a comprehensive overview of the individual's financial health. Assets can range from cash, investments, and real estate to personal property, while liabilities may include loans, mortgages, and other debts.

Why Lenders Care: Lenders may require a PFS from borrowers to assess their ability to repay a loan, especially in cases where the loan is not fully secured by collateral or when the borrower is seeking unsecured credit. The PFS offers lenders a snapshot of the borrower's financial resources and obligations, helping them evaluate the risk of lending. For personal loans, credit lines, or when personal guarantees are involved in business loans, the PFS is crucial in underwriting the loan.

A strong PFS, showing substantial net worth and healthy cash flow, can reassure lenders of the borrower's financial stability and repayment capacity. Conversely, a PFS indicating high levels of debt or insufficient assets might raise concerns about the borrower's ability to meet additional financial obligations, potentially affecting the loan terms or the decision to lend.

Example in Loan Agreement: "As part of the loan application process, the Borrower has submitted a Personal Financial Statement dated January 1, 2024, which discloses a net worth of $500,000, with total assets valued at $800,000 and total liabilities of $300,000. The Lender has reviewed the Borrower's PFS, considering it in conjunction with other financial information provided, to determine the Borrower's creditworthiness and ability to fulfill the financial commitments outlined in this Agreement."

Conclusion

Navigating loan agreements requires a keen understanding of complex financial terms, whether you're a lender or a borrower. While this guide offers a solid foundation, timely legal guidance can significantly enhance your negotiating position and safeguard your interests. Munizzi Law Firm specializes in business and real estate law, providing the legal guidance needed to navigate your next loan transaction with confidence. Whether securing favorable terms or ensuring compliance, our team is here to support your success. Reach out to Munizzi Law Firm for assistance in making your next financial move a success.

‍