Small Business Owners and Consumers Must Stop Agreeing To These Five Contract Provisions
When it comes to signing a contract—whether it be for real estate, a loan, a lease, a car, boat or any type of service—most people will sign a contract with the intention of following its terms.
They enter into a contract thinking that its provisions would never apply to them, as they do not intend on defaulting. But in the event of unforeseen circumstances, these terms and provisions are meant for when one defaults.
Here are the five harshest provisions commonly found in financing agreements. They are listed in no particular order of severity, but suffice to say, a borrower should avoid having these terms included within the contract if they can. If they can’t, a solution is suggested on how to reduce the intended consequences of such provisions.
Prepayment Penalty (“PPP”)
Essentially, this term makes one pay an additional percentage of the loan balance when paying the balance off in advance of the intended due date. For instance, a 3% prepayment penalty on $100,000 means that a fee of $3,000 is owed to the lender. What a waste.
Solution: If the lender insists upon having a prepayment penalty, then limit the time for which the term is valid. Limit a prepayment penalty for the first 3 years or negotiate a penalty that gets reduced in every passing year. For example, a 5% PPP in the first 2 years, gets reduced to 3% for the next 2 years, and 1 % thereafter. The best solution is to have no PPP, or wait until the time for the PPP expires.
Having a balloon payment on a loan or promissory note means that the loan may be amortized over a specified time, but the entire balance is due before the loan being fully amortized. For instance, a $50,000 loan with a 30-year-amortization and a 5-year-balloon means that the payments are spread over 30 years, but the remaining balance on the $50,000 is due in 60 months. Failure to pay the balloon payment means that the borrower is in default.
Solution: Try to extend the balloon for a longer period—say, a 10-year-balloon instead of a 5-year-balloon. Also, condition the balloon’s effect on consistent payment history: the balloon is extended, or goes away all together if all payments are paid timely.
Please note: A PPP provision can exist even when there is a balloon payment provision, but the PPP cannot be charged when paying off a balance pursuant to the balloon requirement itself.
A guaranty is a provision. A guarantor is an individual or company that signs an obligation on behalf of another bound to a contract, usually to ensure that the primary borrower will perform under the contract’s terms. If the borrower fails to perform a service or make payments, the guarantor will be called upon to make the payments, pay the entire loan balance, or step in to perform the required service. Being a guarantor is different than being a co-maker (discussed below). Neither status is good, but a guarantor is not obligated on a loan until a default is actually declared by the lender.
Solution: Limit exposure as a guarantor by agreeing to be liable for a service or balance for a specified amount. For instance, a guarantor can guaranty only the first $100,000 of a $700,000 loan, or negotiate a fading guaranty, which means that the exposure is reduced as time goes by. “After five years, the guaranty is null and void or reduced by half the original balance.” Another solution is to have the guarantor liable only when the lender has exhausted all legal options against the original borrower and has failed to collect.
Co-makers are basically joint borrowers on an obligation. If one borrower doesn’t pay, then the other remains liable for the debt. There are no requirements for a lender to pursue and exhaust all legal remedies against one co-maker before pursuing the other. The lender can pick and choose who to pursue – one or both. It also doesn’t matter that one co-maker may get all the benefit of a contract (known as consideration) while the other may have received nothing from the contractual relationship.
Solution: Co-makers or co-signers, are jokingly called “idiots with pens”. That’s harsh. But there are times when a co-maker is needed, such as on a student loan or car note. The best solution is to reduce the time frame in which the co-maker’s liability remains in effect, or base the provision on performance. For example, when one borrower pays timely for 24 months, then the co-maker shall be released from the obligation.
Negative amortization occurs when there is an increase in the principal loan balance because the monthly payments are deficient and fail to cover the monthly interest. The remaining balance of interest due is added to the principal balance. A provision against negative amortization can be included in a contract and a default can be declared.
Solution: Negative amortization can occur if the borrower needs a lower payment for a short period of time. Ask the lender to modify the loan to accommodate a lower payment. If not, then the lender may spread out the difference in interest over several payments at a later date. Also, one can ask to extend the time before a default would be declared.
There are many scenarios concerning the above listed provisions and their impact. In some instances, the easiest way to prevent a lender from invoking a material default is to simply “cure” the default, or have the lender waive the default, by giving the borrower a “second chance”. Times remain difficult for some lenders, just as for businesses. Understanding the implications of contract provisions is the first step to crafting and negotiating terms that one can live with when endorsing a contract. Terms that may or may not ever apply to one’s own situation.