A promissory note is a written promise by a borrower to repay a loan to a lender according to predetermined terms and conditions.
Before the requested fund is provided, the lender and the borrower document terms that have been mutually agreed upon on a promissory note, such as the repayment schedule, interest rates, and collaterals.
Key Provisions
- Parties: Full name, type (individual/entity), and addresses of the borrower and the lender.
- Principal Amount: The total amount of money being loaned.
- Payment Terms: When and how payments should be made.
- Interest Rate: The rate of interest charged on the principal.
- Borrower’s Signature: Essential for validity (lender’s signature is optional).
When to Use a Promissory Note
Common scenarios in which you may use a promissory note can include:
- Informal loans: lending money to friends or family members;
- Real estate loans: providing private mortgage to a home buyer;
- Business loans: financing a business for start-up or expansion;
- Vehicle loans: funding for the purchase of a car, boat, or other motor vehicle
Promissory notes are typically used for less complex loans or when there is a prior acquaintance between the lender and the borrower. By using promissory notes, lenders ensure legal protection for themselves in the event of a borrower’s failure to return the borrowed money.
Why Use a Promissory Note?
- Legal recourse: It provides a lender with legal recourse if a borrower fails to repay the loan;
- Evidence of debt: It acts as a record of the transaction that can be used for accounting and tax purposes;
- Additional flexibility: Its transferability offers lenders an effective way to manage risk.
Tax benefits of promissory notes
The IRS permits annual tax-free money gifts of up to $17,000 per individual or $34,000 per couple, excluding direct payments for education or medical costs.
Upon reaching this limit, a family loan can be facilitated through a promissory note at IRS-specified low-interest rates, keeping the interest and principal within the family as a tax-efficient support mechanism.
How to Write a Promissory Note
Step 1: State the parties
Start by identifying both the borrower (the party receiving the loan) and the lender (the party who will be paid back).
The parties can be individuals or business entities, such as corporations or LLCs. If either party to the promissory note is a business entity, a representative must sign on its behalf.
All lenders or borrowers should include their names on the note if there is more than one lender or borrower.
If the borrower’s financial stability is questionable, the lender may demand a cosigner with good credit as a safety net for the promissory note. By jointly signing the note, the cosigner undertakes to settle the loan if the borrower does not pay it back.
Step 2: Outline repayment terms
Next, you should clearly outline the following details about the loan and how it will be paid back:
- Principal amount: The total amount of money borrowed;
- Payment schedule: If the borrower plans to pay in installments, in a lump sum, or on demand;
- Collateral: If the borrower needs to guarantee the loan with their asset(s) and secure the note;
- Late fee: Whether there will be an additional fee if the payment is not made on time;
- Interest: If there will be any interest added to the loan and at what rate;
- Acceleration: If the lender can ask for the whole loan to be paid back at once, regardless of the original payment plan;
- Prepayment: If the borrower can pay back the loan early without any extra charges;
- Consequence: What happens if the borrower cannot repay the loan.
When determining repayment terms, the lender should consider carefully the borrower’s financial condition and the risks associated with the loan.
For example, if your borrower has low credit, you may opt for a secured promissory note in case the borrower defaults. If your borrower expects a large sum of money in the future, one lump sum payment may be more appropriate than installment payments.
Determining the Payment Schedule
To help you make an informed decision, below is a glance at the pros and cons of the three typical payment schedules for promissory notes:
Lump Sum
- What it is: A one-time payment where the borrower pays the total amount at the end of the loan term.
- Suitable for: Individuals who anticipate having the total amount of the loan available by a specific date (i.e., from a tax refund, an inheritance, a bonus at work)
Pros
- Quick, full payment
- No ongoing collection management
Cons
- Higher default risk
- Lose potential interest income
Due on Demand
- What it is: The lender can demand immediate payment at any time.
- Suitable for: Individuals or businesses lending to someone they trust deeply, like a close friend or family member, or in cases where the lender wants flexibility in requiring repayment.
Pros
- Can request repayment at any time
- Useful when anticipating early repayment
Cons
- Uncertain repayment timing
- Can strain borrower relationship
Installments
- What it is: The loan is repaid in regular, set amounts over time.
- Suitable for: Most traditional loan scenarios, such as personal loans, auto loans, and home mortgages, where the borrower pays the loan over time in regular amounts.
Pros
- Steady and predictable cash flow
- Potentially higher interest income
Cons
- Extended default risk
- Requires ongoing collection management
Step 3: Consider additional terms
Before you complete the promissory note, consider including additional provisions to make your note more comprehensive, such as:
- Amendment: How the note could be altered;
- Governing law: Which state laws that will be applied for the note;
- Joint and several liability: How all co-borrowers share responsibility for the repayment of the note, collectively and individually;
- Right to transfer: If the lender has the right to transfer the promissory note to a different party and have them collect payment instead.
Step 4: Sign the note
Once the principal terms of the note are agreed upon, the borrower should sign the note. While it is optional, including the lender’s signature is also good practice.
Although not legally required, it is recommended that the promissory note be notarized if the loan involves a significant amount of money or when the terms are complex or could potentially be disputed.
Money should be exchanged only after the note is signed. In addition, every party to the note should receive a copy, and the lender should store the original securely.
What happens if I lose the original note?
A copy will suffice if the original is lost. If neither the original nor a copy is present, try and find other ways to prove the agreement (i.e., text exchange). The borrower could technically ghost when there is no proof that the loan happened.
Step 5: Enforce the note
Generally speaking, there are three potential outcomes once a promissory note is in effect:
- Timely repayment
If the borrower repays the total amount per the note’s conditions, the lender should provide a loan release form to relieve the borrower of any further obligations related to the note.
- Delayed repayment
In case of late payment, the lender is required to issue a demand letter requesting the payment and any applicable late fees. If the borrower still fails to make up for the payment, the lender must evaluate the financial viability of initiating legal action.
- Non-repayment
If the borrower completely defaults on payment, the lender can pursue repayment (and collateral repossession, if applicable) via small claims court (a less expensive venue that doesn’t permit attorney representation, thereby eliminating attorney’s fees) for loans under the state limit. Litigation may be necessary if the loan amount exceeds the lender’s state limit.
Taking Legal Action
A comprehensive list of documents required when pursuing legal action for non-payment of a promissory note may include:
- The note itself. The original agreement that indicates the borrower’s promise to pay and contains your signatures. A copy will suffice if the original is lost.
- The demand letter. This serves as proof that you have formally demanded repayment.
- Correspondence. Any emails, letters, or other communications with the borrower regarding the loan and repayment.
- Other supporting documentation. This might include collateral agreements, personal guarantees, or other relevant contracts.
- Specific small claims court forms (if applicable). Depending on your location and the claim amount, you may need to fill out specific forms for small claims court.
It’s important to consider that litigation costs may exceed the recoverable amount. Furthermore, even if a judgment is in favor of the lender, recouping the funds can be challenging if the borrower lacks the financial means to settle the debt.