What’s the difference between an IOU, a Promissory Note, and a Loan Agreement?

During tough economic times, with many people dealing with the burden of debt from student loans and mortgages, more and more individuals are opting to borrow money from friends and family members.

According to a recent online poll by consumercredit.com, 82% of respondents would lend money to a family member that needs it, and 66% of people would be willing to give money to a needy friend.

It can certainly be difficult to say no when you see someone you care about struggling financially. The question is, if you choose to lend them money how can you ensure they pay you back?  The following article describes three different ways to put the loan down in writing so you are not only both crystal clear about the terms of the agreement, but are also legally protected.

1. IOU FORM

What it includes

1. Amount owed
2. Due date of loan
3. Name of lender (signature not necessary)
4. Name of borrower (with signature)

When to use it

• If a close friend or family member asks to borrow money
• If you’re looking for some form of documentation that’s not too formal

What makes it different

• The simplest and least formal of the three forms
• Only the borrower’s signature is needed

As is standard on an IOU form, there won’t be any interest on the loan, and there will be a date included on the form outlining clearly when the borrower needs to pay the lender back. It takes them only a few minutes to write up and is laid out simply so both of them are clear about the details of the loan.

2. PROMISSORY NOTE

What it includes

1. Amount owed
2. Due date of loan
3. Name of lender (signature not necessary)
4. Name of borrower (with signature)
5. Installment dates and payments
6. Collateral terms
7. Interest charged (if any)

When to use it

• If you’re investing in a business, paying for medical expenses, credit card debt, fees for child adoption or a special event like a wedding
• If you think the other person may not pay and you need to secure collateral
• If you think they might need to pay you back in installments
• If you want to charge them interest on their loan

What makes them different

• There are 2 types: Secured and Unsecured Promissory Notes
• Secured Promissory Notes involve collateral terms (items that the lender can take if the borrower doesn’t pay)

The lender should get the borrower to sign a Promissory Note. They don’t need to charge any interest this time, but they could use this form again in the future if needed, keeping both of them in the clear about the terms of the agreement.

3. LOAN AGREEMENT

What it includes

1. Amount owed
2. Due date of loan
3. Name of lender (signature not necessary)
4. Name of borrower (with signature)
5. Installment dates and payments
6. Collateral terms
7. Interest charged
8. Consequences of defaulting (if payer doesn’t pay, what happens)
9. Late charges that could be incurred
10. Prepayments (including discounts if the borrower wants to pay in advance)
11. Joint and several liability
12. Right to transfer (if the lender wants to transfer the loan to someone else).

When to use it

• When there is a substantial amount of money involved in the loan
• If you want to charge the borrower late fees if make late repayments
• If you want to include the consequences of defaulting (e.g collateral repossession, enlisting a debt collector and/or the filing of a lawsuit against the borrower).
• If you need capital to start a business, purchase a home, repay a student loan or buy a new car for yourself or someone else.

What makes them different

• The most formal and detailed of the three types of loan agreements
• Can include joint and several liability; all borrowers are responsible when one doesn’t pay
• Can include consequences of defaulting; what happens when the borrower doesn’t pay
• Any late charges that could be incurred
• Prepayments; including discounts if the borrower wants to pay in advance
• Right to transfer; If the lender wants to transfer the loan to someone else

In Summary

The type of written agreement you choose will depend on the circumstances of the loan and the relationship you have with the borrower. Whether the debt is for a small amount using an IOU form, or a larger amount with interest and collateral using a Promissory Note or Loan Agreement, it is critical you ensure the debt is set out in writing to give both of you a clear understanding of the loan terms and conditions.

For more information, read these articles if you need to enforce an existing Promissory Note, or are trying to collect a debt from a friend or family member.