The loan agreement or contract is a very important document and should be scrutinized before appending your signature. The signing of such a document implies that you have read, understood and agreed to the conditions upon which the loan is being granted. There is no easy wiggle room out of the deal when it is finalized, and you must abide by the terms of the contract. There are usually some key sections of the document that require keen attention and should be read in its entirety.
The interest rate is essentially what it is costing the borrower to get the loan. It is an additional payment being added to the principal or original amount borrowed. In rare instances, for example in the case of a student line of credit or construction loan, there may be an interest-only period (where you pay towards the interest and not the principal amount). The interest rate can be either fixed or variable. A fixed rate as the name implies does not change and will remain the same throughout the loan period whilst the floating or variable rate usually fluctuates with the prime lending rate. In most cases, a variable rate would be prime plus an additional percentage point. However, some customers may have the privilege of getting a prime-only rate or even a discount resulting in a rate slightly lower than prime (this is usually based on their credit rating or if they have a good relationship with the lending institution).
Prepayment is the early partial or full payment of a loan. A lump sum payment is often made as a prepayment. The prepayment penalty is the fee that the lender charges if the loan is paid out before the term or if there is a lump sum payment more than what is stipulated in the contract. This clause is commonly associated with mortgages. A closed mortgage term will be associated with a penalty if it is paid out early while an open mortgage can be paid in full at any time without attracting a penalty. Lump sum payment or extra payments is beneficial for borrowers because it allocates more funds to the principal portion of the loan allowing for quicker repayment. This is a smart way to reduce the amount of interest paid hence reducing the cost of borrowing.
Maturity date is when the fixed term of the loans ends while the amortization period is the time it will take to pay off the entire balance of the loan. Amortization is the process of dividing the payments over a period. The amortization period and the term of the loan may be the same for most loans except for mortgages which typically has 5 or 10 years term and is renewed at the end of each term until it is repaid in full. The longer the amortization or term then the lower the payments but more interest will be paid.
Installment payments are made in regular intervals and are necessary to keep the loan in good standing. Payment schedule could be weekly, bi-weekly, accelerated bi-weekly, semi-monthly or monthly. It is important to note that bi-weekly payments are not the same as semi-monthly, therefore use the calendar as a guide. Ensure that your payments are well aligned with your personal cash flow to avoid late or missed payments.It is crucial to avoid overextension and refuse payment amounts that will weigh too heavily on your budget or beyond your affordability threshold.
When the loan is not fully repaid at the end of the term then a balloon payment will be needed at the end of the term or at maturity. A balloon payment is like a lump sum payment that is still owing at the end of the contractual term. It will usually be a different amount from the regular payment.
Check if there is an insurance component because it is possible to decline the insurance provided by the lender especially if you already have a comprehensive coverage which can also be cheaper. Pay attention to whether there is a default interest rate which is higher than the normal rate. Are there any late fees or will the loan be due on demand if there is a missed payment? What are the steps for debt recovery and when would legal action commence? These measures would be considered as consequences for defaulting on the loan.
It is always advantageous to ask as many questions as needed to prevent misinterpretation or misunderstandings. It is mandatory to hire a lawyer for most large transactions especially mortgages or commercial loans, so the lawyer should be able to explain the legalities. Seeking independent legal advice even in situations where it is not compulsory may also be very helpful.