A promissory note is a financial instrument that comes into play at the time of borrowing money. It is basically a legal document that states that the borrower promises to pay the lender a specific sum at a specific date or on-demand. Or, we can say it is a written promise to pay the loan money back.
One may also call it an IOU, a note, or just the simplest loan agreement, but there is a difference between the loan agreement and the promissory note. Since it is a legal document, it is legally enforceable. It is usually a short-term credit tool.
- When to Use a Promissory Note?
- What a Promissory Note Includes?
- Parties to Promissory Notes
- Features of a Promissory Note
- Types of Promissory Notes
- How to Execute Promissory Notes?
- Promissory Notes for Students
- Promissory Notes for Corporate
- Final Words
When to Use a Promissory Note?
As said above, this note comes into play when giving or taking a loan. It could be any type of loan, be it a car loan, student loan, mortgage, personal loan, business loan, working capital financing, or more. One could use this note even when they give money to a friend or a relative. Having such a note is a legal record, and protects the lender in case anything goes wrong.
What a Promissory Note Includes?
As you could expect, it lays down the terms and details of the debt or loan. A usual promissory note includes the following points:
- Name and address of both the parties- the borrower and the lender.
- The amount that the borrower gets from the lender and when.
- The interest, if any, payable against this borrowing.
- Details of the collateral, if any, offered against this loan.
- Whether the borrower will pay back in one lump sum, weekly or monthly, or in any other way or installments.
- When the borrower makes the repayment, the amount he or she needs to pay, and the mode of payment.
- Signature of lender and the borrower.
- Date and place when the document is signed.
- Witness, if any.
The above points are a general format for a promissory note. However, the parties, if they want, can customize the note the way they want, or include the language they want.
Parties to Promissory Notes
Promissory notes primarily include three parties. These are:
It is the borrower. Or, we can say it is the person who promises to pay the lender (drawee) a specific sum of money at a specific date. We can also call drawers or makers.
It is the lender. Or, we can say, it is the person whom the drawer promises to make the payment.
The payee is whom the drawer makes the payment. Usually, the drawee and payee are the same, except in cases when the note is transferred to another person. For example, A takes a loan of $1,000 from B. They both form a promissory note where A is drawer and B is drawee. However, before maturity, B transfers the note C. In this case, C is the payee. The person who ultimately receives the payment as per the Promissory Note from A.
Features of a Promissory Note
Following are the important features of a promissory note:
- It could be in writing, or in print.
- It is a promise from the borrower to pay the money on a specific date or when the lender asks.
- Such a document includes the signature of both parties and is stamped.
- It is an unconditional promise. Or, the promise to pay back the money must not depend on any condition or situation.
- The payment must be made in the common legal currency.
- The note contains all the details one may need to determine what the transaction was and what the two sides agreed on.
- It can be issued by financial institutions, or by small companies or individuals.
Types of Promissory Notes
Following are the types of promissory notes:
It is usually for a lump sum repayment. For example, a borrower takes a loan of $5,000 from a friend and agrees to make the full repayment a month later. In this, there is no payment schedule, and the amount is due on a certain date. The lender may or may not charge the interest.
As the word suggests, in this, the payment is due when the lender demands it back. In practice, however, the lender does give reasonable advance notice to the borrower.
It involves the use of promissory notes when taking a loan from a friend or family.
Such notes come into play when taking a loan from a commercial or financial institution, such as banks.
It is the same as the commercial note with one difference. In case of default, the lender has the right to take over the property until the borrowers clear the debt.
Such a note allows businessmen to raise funds for the business. Basically, it is a declaration that the business has got money from an investor, along with other details. Such notes are governed by securities laws. So, in a way, such notes allow the business to get funds without borrowing from a bank.
Such notes are secured by something or collateral, such as a house, car, etc. In case of default, the lender can forfeit the security.
These types of notes are not backed by any collateral or security. Such a note depends on the borrower’s capability to pay back.
Except for the first one, all other promissory notes can be either simple or complex. The complex notes are for transactions, such as mortgages and car loans. These notes include the repayment schedule, interest rate, and more.
How to Execute Promissory Notes?
In most cases, when you lend on the basis of a promissory note, the borrower does pay back as agreed. However, in some instances, the borrower may default or doesn’t show any intention to make the repayment. In such a situation the only course left with the drawee or the promissory note holder is to enforce this indenture legally.
However, before you go for legal action, the lender can use other means to get the payment from the borrower. The first thing you need to do is give notice to the borrower asking him or her to make the payment. In the letter, you may give the borrower a grace period to pay back the money.
Also, the drawee or the note holder needs to communicate with the borrower. Talk to the borrower if they need some more time to make the payment, or they could make a partial payment. If both sides agree on a partial payment or a new payment schedule, then a new agreement needs to be signed by both parties.
In case, the two sides agree on the new terms of payment, then they will amend the original promissory note with an Amending Agreement. For an Amending Agreement, it is important that the two sides give their consent.
Another way you can execute the note is by selling it to a debt collector. A debt collector usually buys the loan from the lender at a concession. After this, it is their responsibility to collect the debt.
If the debt collector option also doesn’t work, then your only option is to sue the borrower. Since these notes are legally enforceable, you can sue the borrower.
Promissory Notes for Students
In the U.S., there is a concept of promissory notes when taking some types of student loans. Usually, private lenders ask the student to sign such a note for every student loan they take. Also, in some federal student loan, the issuer makes students sign a single, master promissory note. This allows students to take multiple federal loans on the same note as long as they meet the criteria of the note.
Like with any other promissory notes, the student notes also include all relevant details of the debt or the loan.
Promissory Notes for Corporate
Along with debt, promissory notes are very popular among the corporate as well. They allow businesses to get short-term credit. For example, if a company hasn’t got the payment from the debtors and it has cash flow issues, then it can ask its creditors to take a promissory note. The note would say that the company would make the payment once they get the payment from accounts receivables.
Similarly, a corporate can issue promissory notes to a financial institution to get a temporary loan. Moreover, firms that have already used normal financing options, such as bonds, can go for promissory notes to get more funds. The interest rate, however, in such a case would be very high.
Usually, corporate needs to register their promissory note with the SEC (Securities and Exchange Commission).
Promissory notes are a very important financial tool. It creates a legal record of the amount you gave as a loan along with all relevant details. Moreover, it is also a very useful source of finance for corporate.
Continue reading about other types of Negotiable Instrument.