We created the LendingKarma loan education center to help educate and take some of the mystery and complexity out of loan agreements and the person-to-person lending process with plain English definitions and descriptions. Please feel free to contact us if you think you've found an error, have questions, or if there's a topic that you'd like to see covered here in the education center.
A loan agreement is a contract between one more more lenders and one or more borrowers which states that the lender(s) will lend a specified amount of money to the borrower(s) and that the money will be paid back at some point in the future. A loan agreement often goes by many names including:
  • Promissory note
  • Loan contract
  • Loan agreement
These names are often times used interchangeably but they all mean the same thing. There are various types of loan agreements and payment schedules out there but the terms above are used to refer to a loan in general.
There are two main types of loan agreements commonly used: secured and unsecured. There are different variations of payment schedules that can be used with each of these loan types. (See "What about interest only, adjustable rate, balloon, and other types of loans?" for more information)
A loan that is made to a borrower where the borrower uses something of value as collateral for the loan. This allows the lender to recoup at least some or all of their money lent by either keeping or reselling the collateral. When a secured loan agreement is created it is generally supplemented and supported by a security agreement (See "What is a security agreement?" for more information) for the collateral (See "What is collateral?" for more information).
Collateral is generally a tangible object (but not always, for example intellectual property or other non-tangle property may be used) of value that is offered by the borrower in the event they are unable to make good on their loan repayment. The lender is able to take possession of the collateral almost immediately in the event that the borrower is unable to repay the loan. Depending on the type of collateral there are different ways of ensuring that the collateral is properly tied to the loan agreement. If the collateral is:
  • Real estate - A deed of trust must be filed with the county recorder's office in addition to the execution of a mortgage agreement.
  • Non-tangible property - if you are considering using intangible personal property (bank accounts, stock in a corporation) or intellectual property (copyright, trademark, patent) as collateral for the loan, you should consult an attorney.
  • Tangible property that is not real estate - A security agreement should either be created in a separate document or included in the terms of your loan agreement document and a UCC (See "What is a UCC form?" for more information) form filed with the appropriate state. (Normally the same state whose laws govern the promissory note.) These actions will protect the interests of the lender in case of borrower default.
A security agreement is a document that can be used to supplement a promissory note. Security agreements allow lenders to take property if a default occurs. You can execute a secured promissory note without a separate security agreement. LendingKarma secured loan documents contain language in the promissory note for collateral thus it's not necessary to draw up a separate security agreement for use with our promissory note. However for added security you may also want to file a UCC form with your state. (See "What is a UCC form?" for more information).
A UCC form, otherwise known as a financing statement, is a form that is filed with the appropriate recording agency that publicly declares the lender's interest in the collateral specified in the promissory note and security agreement. Once a UCC form is completed and filed with the correct governmental authority, the lender’s interest in the property is considered “perfected.” This means that if future lenders also seek a security interest in the same asset, the lender with the perfected interest would have top priority and could take the property for themselves after a default.
It depends. In most cases, it’s enough to simply document the collateral (which you can do using LoanCreator™) since the lender and borrower know and trust each other. In other cases, it may make sense to file a UCC form to give the lender more security in the case of default.
If you are thinking of filing a UCC form for your personal loan, here are some things you should know:
  • The proper UCC form to file is called a “UCC-1” form (there are several other types)
  • You can get a UCC-1 form on the Secretary of State’s website for your state (We've provided a list of links to all 50 states for your convenience.)
  • Many states also allow you to file a UCC-1 form electronically on their website for a nominal fee. Other states require you mail in a paper form.
Want More Information? To get more information on UCC-1,
download a form or even file electronically, select your state:
Creating a loan that involves real estate (otherwise known as a mortgage) requires a bit more documentation than most other loan types. Below is an overview of some of the terms and at least some of what you'll need to do to create a mortgage.

Mortgage Documents
A mortgage involves two important legal documents: a promissory note and either a mortgage document or deed of trust.

Promissory Note: The promissory note (also called a mortgage note or real estate note) is a note the buyer gives to the lender promising to repay the amount of the loan plus interest. The note also states the amount of time the buyer has to repay the loan and what action the lender may take if the buyer fails to make the required payments. The note should state the interest rate and specify whether it is fixed or variable. The note also may contain provisions such as a balloon payment.

It is important to note that the borrower’s typical monthly payment to the lender is not solely for principal and interest owed on the note. Monthly payments might also include escrow payments for property taxes and insurance.

Mortgage Document or Deed of Trust: The borrower gives the lender either a mortgage document or a deed of trust, depending on the state where the transaction takes place. Both a mortgage document and a deed of trust serve the same purposes of pledging the borrower’s title to the property as security for the loan and giving the lender a claim against the property in the event of default. A mortgage document and a deed of trust have a few key differences:

Mortgage Document: A mortgage document is used in most states, including Florida, Illinois and New York. A mortgage involves only two parties: the borrower and the lender. It creates a lien on the property, which is recorded in the public land records. With a mortgage, the borrower has full title to the property but may not transfer ownership until the debt is paid off and the lien is released. If the debt is not paid, the lender has the right to sell the property, usually through judicial foreclosure.

Deed of Trust: Many states, including California and Texas, use a deed of trust instead of a mortgage. The deed of trust is recorded in the public records to give notice that the property has a lien on it. A deed of trust involves three parties: the borrower, the lender and a third-party trustee, such as an attorney or title insurance company, who holds temporary title until the debt is paid and the deed of trust is cancelled. If the debt is not paid, the trustee may sell the property. The lender must give the trustee proof that the debt is delinquent and ask the trustee to foreclose. Foreclosure typically bypasses the court system.
A loan that is made to a borrower where no collateral is used for the loan is called an unsecured loan. This type of loan is riskier for the lender because if the borrower is unable to pay there isn't as much of a guarantee (compared to a secured loan agreement) that they will be able to recoup the money lent to the borrower. The lender would have to go to court to demand payment if a default occurred.
Adjustable rate, interest only, balloon, and other common terms for loans refers to the type of payment schedule for a given loan. Loans with these payment schedule types can either be secured or unsecured. It's easiest to make that distinction to more easily understand the possibilities for a loan. While there are two main types of loan agreements (See What types of loan agreements are there? for more information) each type can have a myriad of payment schedule options. Here are some of the more common payment schedule options supported by LendingKarma (Either secured or unsecured):
  • Lump sum - The loan is repaid in one payment on a specified date in the future of the entire principal plus any interest accrued over the loan period.
  • Demand payment - Much like the lump sum payment a demand loan is also repaid in one payment of interest and principal but unlike the lump sum payment a demand payment loan does not have a specified date of repayment and instead is at some point in the future when the lender demands payment. The borrower has to repay the loan within the time period specified in the loan agreement.
  • Amortized fixed rate interest and principal - This is the most common type of loan. A payment schedule is created and equal payments containing interest and principal are made at regular intervals until the loan is repaid.
  • Fixed rate interest only with balloon - This type of loan creates a payment schedule with payments that are only interest payments until the final payment which is interest and the original principal.
  • Amortized fixed rate interest and principal with balloon - Similar to the amortized fixed rate loan above this loan also is repaid on a payment schedule of equal payments containing interest and principal but at some point during the loan (typically at the end) a balloon payment is made which has the effect of either shortening the payment schedule duration or lowering the payment amount since a larger portion of the principal will be repaid by the balloon payment.
Here are some less common payment schedule options that aren't currently supported by LendingKarma but are still somewhat commonly used. These payment types are similar to their fixed rate variants with the exception being that the interest rate changes one or more times during the course of the loan:
  • Amortized adjustable rate interest and principal - A payment schedule is created and payments will vary in amount based on the current interest rate for the loan. All payments contain interest and principal are made at regular intervals until the loan is repaid.
  • Adjustable rate interest only with balloon - This type of loan creates a payment schedule with payments that are only interest payments, which will vary in amount based on the current interest rate, until the final payment which is interest and the original principal.
  • Amortized adjustable rate interest and principal with balloon - Similar to the amortized adjustable rate loan above this loan also is repaid on a payment schedule of varying payment amounts containing interest and principal but at some point during the loan (typically at the end) a balloon payment is made which has the effect of either shortening the payment schedule duration or lowering the payment amount since a larger portion of the principal will be repaid by the balloon payment.

Interest rate

The loan agreement should clearly state the interest rate for the loan and whether it is compound or simple interest. For the IRS to consider the money a mortgage loan and not a gift, the lender must charge an interest rate no lower than the minimum rate required by the federal government, (Known as the Applicable Federal Rate (AFR)). If the lender charges less than the AFR, the IRS may view the forgone interest income as a gift from the lender(s) to the borrower(s).

For lenders:

  • Any interest you earn on a private loan is considered income by the IRS and as a result considered taxable. You may make a gift of that income, up to $14,000 each year, which is the Annual Gift Tax exclusion ($28,000 if made by a couple; $56,000 if made by a couple to a couple).
  • In the event of a default or an audit, you must prove that your transaction was legitimate and not a gift. In order to write-off a defaulted loan or mortgage as bad debt, you must show that you had documentation, that your loan was not a gift, and that you tried to collect on it. This means that you must keep accurate and detailed records of the specifics of the loan, including all payments, interest rates, and other relevant documentation. LendingKarma can help with creating your promissory note and recording your mortgage payments so that you have detailed interest and payment information.

For borrowers:

Interest paid by the borrower can still get the benefit of a federal tax deduction for interest paid just like a traditional bank mortgage when the loan is structured properly. The loan must be structured, documented, and recorded as a private mortgage rather than an unsecured loan that is not recorded with the appropriate registry of deeds.
We do recommend that you consult your tax advisor regarding any changes to the tax laws which may affect the ability to deduct mortgage interest payments.
If you're a little uncertain about your loan agreement needs and would like to speak to an attorney to help guide you in the right direction for your situation, we've partnered with JustAnswer to provide a cost effective way to get the legal advice you're looking for. Just type your question in the box below to get started.

The information on this page should be considered general guidance and used for informational purposes only. It is not intended for use with any specific transaction or goal. Every transaction is unique and you should consult a licensed legal or real estate professional (if your transaction involves real estate) in your state with questions about your specific loan transaction or any recent changes to the laws of your state that might affect your loan. We recommend that you consult a tax advisor and/or an attorney before entering into a financial transaction of this nature.
LendingKarma.com is not a law firm and does not provide legal advice or tax advice. LendingKarma.com is not a lender or a loan broker and does not originate loans on behalf of other parties.