Generally, a promissory note is an agreement to pay a specified amount of money to a specific person or institution, or the bearer of the note, at a fixed time or on demand. From a legal perspective, these notes are considered unconditional agreements.
These agreements, sometimes called notes payable in accounting terms, most commonly cover short-term financing for companies, such as loans or deferred payments for goods or services. Promissory notes are often used for other types of loans, as well, including an individual borrowing money from another individual; borrowing money from a private institution such as a bank; a loan with a specific amount of interest accrued; a written record to determine monthly payments for a specific period of time.
Promissory notes are most often employed when a verbal contract is not enforceable enough. The document will include the full names of both the payer and payee (or lender and borrower), and contact information for both parties including addresses and telephone numbers. The principal sum of money will be stated clearly, and along with date(s) of expected payment(s). If interest applies, the percentage of interest must be clearly stated as well. Any penalties for paying late or missing payments, especially if both parties agree to instalment payments, should be outlined. Although witnesses are not legally required, the validity of a promissory note holds up better in court if witnesses also sign the agreement between borrower and lender.
Common Payment Options Included in Promissory Notes
If you offer a large enough loan, you should consider a promissory note as a legal agreement for terms of payment. Here are the most common ways to collect money on your promissory note:
- Lump sum payments. This means that the borrower will repay the lender in full at the agreed-upon time.
- Due on demand. This means that the borrower will repay the lender when the borrower asks for the money. This agreement is most often for a full repayment.
- Instalment payments. If the borrower cannot pay the full sum of the loan back, a payment plan can be set up in the promissory note; once paid in full, the promissory note is no longer valid.
- With interest. Interest is often collected on loans, mortgages, and other large sums if the borrower will repay the borrowed money over a period of months or years. Interest is repaid first, then additional money goes toward the principal (aka the original amount borrowed) after.
Promissory Notes are not Loan Contracts
Although promissory notes and loan contracts have many clauses and legal considerations in common, loan contracts specifically state the lender’s rights to recourse if the borrower defaults on the loan. Promissory notes do not hold rights for the lender or borrower, making them less enforceable by many businesses and courts of law.
However, a promissory note can outline specific penalties for the borrower for defaulting on payments or violating terms of the agreement. Security agreements are also often attached to promissory notes, to define the payor’s collateral assets.