When do you need to use a promissory note?
Different types of promissory notes include business loans, student loans, car loans, and personal loans between friends and family members. You should use these written agreements when you lend or borrow large sums because they ensure that both borrowers and lenders understand the details of the loan and consequences for nonpayment. When terms of the agreement are comprehensive and the document contains all the necessary signatures, promissory notes are considered legal documents that protect both parties.
What to include in a promissory note:
- Names and addresses of both parties
- Amount of money borrowed (principal amount)
- Amount to be repaid (principal and interest)
- When and how often payments will be made (payment schedule, or “due dates”)
- Interest rate and repayment specifics
- Time frame and maturity date (date the loan will be fully repaid)
- Consequences for late payment (late fees)
- Consequences for failure to pay the full amount
- Identification and description of collateral or property securing the loan
- Statement of any rights of the lender to transfer or assign the note to someone else
- Date and place of issuance
- Signature of both lender (payee) and borrower (payer)
What’s an example of a promissory note?
You can find examples of promissory notes at legal resource and personal finance sites. If you don’t see one that meets your specific needs, you can cut and paste elements from several to create a custom promissory note template of your own. Use Adobe Acrobat to make a fillable and signable PDF file that you can easily share.
A concise promissory note might look something like this.
Quick tips for borrowers.
If you are the borrower, protect yourself from exorbitant rates and check your state’s usury laws. Also check to see if you must pay interest on late payments. This can increase your cost of borrowing if you don’t keep your payments current. If the note is for business purposes, make sure that the borrower is the business, not you personally. You don’t want to have to pay the debt yourself if the business can’t pay. Generally, it’s a good idea to consult a lawyer before borrowing money.
How promissory notes can be useful for your business.
For small businesses, promissory notes offer flexibility to both borrowers and lenders. For family members or business partners who’ve already built relationships and trust, you can execute a promissory note without legal or notary costs, making it cheaper to prepare than a traditional loan. Also, parties can specify exactly how and when payments will be made. In this situation, the borrower doesn’t have to give up equity or go through a costly security offering.
Promissory notes can also help businesses secure capital from interested investors who aren’t ready to fully commit to the company. Of these convertible promissory notes, there are three types: 1) the investor gets the option to convert their loan into stock or interest in the company at the end of the loan, 2) the borrower gets the option to repay the loan or grant equity in the company to the investor, or 3) the investor receives equity if the borrower defaults.
A promissory note isn’t always the best option for borrowers. Before you borrow, you should feel good about your cash flow and your ability to repay the loan. With large sums of money, you may want a more formal agreement, and that agreement might offer a better interest rate. Also, if the loan is for a business and the term of the loan is longer than nine months, the promissory note is considered a security and must be registered.
Borrowers should also be well-informed when it comes to the terms of certain types of promissory notes. For example, a demand promissory note would require the borrower to immediately pay back the loan in full whenever the lender “demands” it back, at any time after they borrow the money. This could be a risky term to agree to, depending on the borrower’s ability to repay.