A promissory note is a pledge of promise. They are relatively simple documents, but it’s important that you know the basics. Keep reading this Business Kitz blog to find out more!
What is a promissory note?
A promissory note is a written promise from an issuer, stating that an agreed sum of money will be paid to a payee, either immediately or by a specific date. We see this kind of document being used when money is lent or borrowed, but it is distinct from a loan agreement. Although it is still a legally binding promise, a promissory note does not have as many legalities and complexities as a loan agreement. Instead, we often see promissory notes being used between two parties that hold an established, trusting relationship, and only a small sum of money is in question. Therefore, these documents are best for low-risk loans.
What do you have to include?
A promissory note is a fairly simple document, but there are a few key aspects that you must include, to ensure the parameters and terms of the loan are clear for both parties. Particularly, the issuer must state whether the money is to be paid on demand, or by a specific future date.
It is vital to also include:
- the involved parties (clearly stating who is the issuer and the payee);
- the timeline for repayment;
- if there is any interest charged on top of the money lent; and
- the signature of who issues the note.
How is this different to a loan payment?
You may have also heard the term ‘loan agreements’ when discussing the lending of money. They are similar to the extent that they both discuss and navigate the terms of borrowing money, but the key difference is that promissory notes are much more simple and have less thorough terms. For example, loan agreements will contain complex details including the conditions of the loan, scheduled repayment instalments and the associated ‘events of default’ terms. Due to these more extensive parameters, it does mean that promissory notes provide greater protection and clarity, especially when dealing with unfamiliar parties or large sums of money.
What are the pros and cons vs a loan payment?
Promissory notes and loan payments are both methods of borrowing and lending money, each with its own set of advantages and disadvantages. Let’s compare the pros and cons of promissory notes and traditional loan payments to help you make informed financial decisions.
- Flexibility: Promissory notes can be highly flexible, allowing the parties involved to negotiate terms, interest rates, and repayment schedules.
- Customization: They can be customized to suit the specific needs of the parties, making them ideal for personal and unique financial arrangements.
- Private Arrangements: Promissory notes are often used in private or informal lending situations among friends and family, offering a level of privacy and trust.
- Quick and Simple: Creating a promissory note is relatively straightforward and does not typically involve extensive paperwork or regulatory requirements.
- Risk: Unsecured promissory notes carry a higher risk for the lender, as there may be no collateral in case of default.
- Legal Complexity: In more complex financial transactions, the legal requirements and documentation for promissory notes can become intricate.
- Enforcement Challenges: Enforcing the terms of a promissory note may be challenging, especially when compared to the legal mechanisms available in traditional loans.
Traditional Loan Payments:
- Security: Loans, especially secured ones, offer a higher level of security for lenders because they have collateral as a backup in case of default.
- Regulation: Traditional loans are subject to legal and regulatory protections, which can offer both borrowers and lenders a clear framework for the agreement.
- Credit Building: Timely payments on traditional loans can positively impact a borrower’s credit score, improving their financial future.
- Professionalism: Loans often involve banks or financial institutions, providing a sense of professionalism and accountability.
- Less Flexibility: Traditional loans come with less room for customization. Borrowers are subject to the lender’s terms and conditions.
- Complex Application: Applying for traditional loans can be more complex, involving extensive paperwork, credit checks, and waiting periods.
- Interest Costs: Traditional loans typically come with interest costs, which can add up over time, making them potentially more expensive.
- Public Records: Traditional loans may appear on credit reports, which can impact a borrower’s credit history and affect their future borrowing capabilities.
What are the types of Promissory Notes?
- Simple Promissory Note
A simple promissory note is the most basic form of this financial instrument. It includes the borrower’s promise to repay a specific sum to the lender within a defined timeframe. These notes are typically unsecured, meaning there is no collateral attached to them. Simple promissory notes are often used for personal loans among family or friends, or in straightforward business transactions.
- Secured Promissory Note
In contrast to simple promissory notes, secured promissory notes involve collateral. In these agreements, the borrower pledges an asset (such as a car or real estate) to secure the loan. This collateral provides the lender with added security in case the borrower defaults. Secured promissory notes are commonly used in mortgage loans and auto financing.
- Demand Promissory Note
A demand promissory note does not specify a fixed date for repayment. Instead, the lender can request repayment at any time by giving notice to the borrower. These notes offer flexibility but may create uncertainty for the borrower, as they can be called in at any moment.
- Installment Promissory Note
Installment promissory notes are suitable for loans that require periodic payments. They outline a specific repayment schedule, detailing the amount due at each interval, as well as the interest rate. Mortgages, student loans, and car loans often use installment promissory notes.
- Unconditional Promissory Note
Unconditional promissory notes are not subject to any conditions or contingencies. The borrower’s obligation to repay is straightforward and not contingent upon any external factors.
- Conditional Promissory Note
Conditional promissory notes include certain conditions that must be met for the obligation to repay to be triggered. For example, a conditional promissory note might stipulate that the borrower only needs to repay if a specific event occurs, such as the sale of an asset or the completion of a project.
- Revolving Promissory Note
Revolving promissory notes are often associated with lines of credit. These notes allow the borrower to borrow, repay, and borrow again, up to a predetermined limit, without the need to create a new promissory note each time. Credit cards are a common example of revolving promissory notes.
- Commercial Paper
Commercial paper is a type of promissory note used in the business world. It is typically issued by corporations to raise short-term funds. These notes are usually sold at a discount and mature in a short period, usually within 270 days. Investors purchase commercial paper at a discount and receive the full face value at maturity.
The Bottom Line
The choice between promissory notes and traditional loan payments depends on the specific circumstances and preferences of the parties involved. Promissory notes offer greater flexibility but come with higher risks, while traditional loans provide security and legal protections but may be less flexible. It’s essential to carefully consider your needs, risk tolerance, and legal requirements when choosing between these financial instruments. It is therefore, highly important to consult with legal and financial experts to ensure that your promissory notes comply with relevant laws and regulations to protect both parties involved.
So, there you go! A promissory note is a legally binding pinky-promise between two parties to ensure that a loan is repaid. If you still have some questions or are worried about a promissory note you have received or written, give our sister company, Legal Kitz, a call at 1300 988 954. You can book a free 30-minute consultation with our experienced and highly qualified team via our website now!