What term describes a written promise by the borrower to pay a sum of money to the lender?

Promissory notes are legal lending documents. If you're going to lend money to someone, you'll need one. You've also likely signed one in the past, if you've ever taken out a loan. Find out when you need a promissory note and how to create one.

A promissory note is essentially a written promise to pay someone. This type of document is common in financial services and is something you've likely signed in the past if you've taken out any kind of loan. If you decide to lend money to someone, you may want to create a promissory note to formalize the loan.

What Is a Promissory Note?

Promissory notes may also be referred to as an IOU, a loan agreement, or just a note. It's a legal lending document that says the borrower promises to repay to the lender a certain amount of money in a certain time frame. This kind of document is legally enforceable and creates a legal obligation to repay the loan.

When to Use a Promissory Note?

A promissory note is used for mortgages, student loans, car loans, business loans, and personal loans between family and friends. If you are lending a large amount of money to someone (or to a business), then you may want to create a promissory note from apromissory note template. This note will be a legal record of the loan and will protect you and help make sure you are repaid.

What to Include in a Promissory Note

A loan promissory note sets out all the terms and details of the loan.

The promissory note form should include:

• The names and addresses of the lender and borrower
• The amount of money being borrowed and what, if any, collateral is being used
• How often payments will be made in and in what amount
• Signatures of both parties, in order for the note to be enforceable

The collateral referenced above is a property that the lender can seize if the note is not repaid; for example, when you buy a home, the house is the collateral on the mortgage.

How to Customize a Promissory Note

Promissory notes should be created to fit the transaction that you are involved in. It's always good to refer to a sample promissory note when you are writing one so that you can be sure to include the right language. There also are different types of promissory notes.

A simple promissory notemight be for a lump sum repayment on a certain date. For example, you lend your friend $1,000 and he agrees to repay you by December 1. The full amount is due on that date, and there is no payment schedule involved. There may or may not be interest charged on the loan amount, depending on what you've agreed.

A demand promissory note is one in which payment is due when the lender asks for the money back. Usually, a reasonable amount of notice is required.

More complicated promissory notes for transactions like mortgages and car loans will also include interest rates, amortization schedules, and other details.

How to Collect on a Promissory Note

If you've lent money to someone using a promissory note, the plan is for them to repay you according to the terms of the note, which in most cases is what happens. But what if they don't meet the terms of the note?

The first thing to do is actually to ask for the repayment in writing. A written reminder or request is often all that is needed. You could send past due notices 30, 60, and 90 days after the due date.

Be sure to talk to your borrower. Can they make a partial payment? Would an extended payment plan allow them to pay up? If you decide to accept a partial repayment of the debt, then you can create a debt settlement agreement with your borrower.

Another option is to use a debt collector. This business will work to collect your note and will usually take a percentage of the debt. You also can sell the note to a debt collector, meaning they own the loan and collect the full amount (this is similar to what happens when banks sell loans to each other). If all else fails, you can sue the borrower for the full amount of the debt.

Promissory notes are a useful way to establish a clear record of a loan—whether between entities or individuals—and to put all the relevant terms in writing, so that there can be no question about the amount of money lent and when payments are due. 

A promissory note also referred to as an IOU or loan agreement is a written promise to pay someone within a specific time period.

This type of document is signed by both parties and is used commonly in various financial services such as loans. The promissory note serves as formal evidence that a loan has been made by one party to another and contains an unconditional promise by the borrower to repay all sums back to the lender under specified terms stipulated in the note. 

When should I use a promissory note? 

As detailed in the next section, promissory notes are used in practically every loan transaction involving borrowing and lending between parties. If you or your business are lending a large amount of money to another individual or company, then you may want to create a loan agreement to act as a legally enforceable record of the loan that will protect you and help make sure you are repaid in due course.

Types of promissory notes 

While straightforward in theory, promissory notes can often seem complex and convoluted in order to fit the transaction that each party is involved in. Because it is used in a vast array of contexts, no two notes are the same and certain features or conditions detailed within the note may dictate different procedures when it comes to how much is paid back at what point in time. The type of promissory note you or your business will issue often depends on the property the loan is being borrowed for. Here are a few of the most popular types of loan agreements: 

Informal IOU – Also known as personal or simple promissory notes, these are typically between one friend or family member to another. This is a written guarantee that the money borrowed will be returned but does not always detail the purpose of the loan and will likely not involve a repayment schedule or interest charge. For example, you lend your friend $1,000 and he agrees to repay you by December 1. 

Commercial IOU– These are considered more formal and may be seen in more high-value business transactions, for example, borrowing money from a commercial lender such as a bank, credit union, or loan agency. The lender in question will often require borrowers to repay the loan with interest. 

Student IOU – When taking out a student loan, the terms and conditions stipulated within a student promissory note will often defer interest from accruing on your loans until after you graduate. Additionally, the start date is often flexible and undetermined until you graduate. 

Investment IOU – A company can issue a promissory note when raising capital from investors. Investment promissory notes ensure that the investors receive their return on investment over a specified period. If the borrower doesn’t pay back the money, the investor may legally take ownership of the company. 

How does a promissory note work? 

After a promissory note is established between parties, there are four main ways for a borrower to repay the loan and interest to their lender.:

Lump-sum – This means that the entire value of the loan will be repaid in one payment to the lender. Lump-sum payments are common with small or informal loans where lenders will tell the borrower when the loan is to be paid back, and the borrower will not have to make monthly payments. 

Installment – This is the most common form of repayment where a specified repayment schedule is established, allowing a borrower to pay back a high-value loan over time. The installments, or payments, are typically made monthly and are equal amounts each month to add up to the total value of the loan. The payments will often include interest until the total principal is paid off. 

Due on demand – Also known as open-ended loans, the borrower must repay the loan when the lender asks for repayment. This form of repayment is more common for informal loan agreement and is typically between friends and family. If a promissory note does not have payment terms listed on the document, it will be considered due on demand. 

It should also be noted that these methods of repayment can be combined. For example, a loan’s repayment conditions may include one lump sum followed by installments, or alternatively, installments may be required without interest for the first few months followed by the interest for the remainder of the loan. 

What terms should be included in a promissory note? 

A promissory note should include all terms and details to which both parties of a loan are agreeing. The most common terms found in promissory notes include the following:

Payor or borrower – Include the name of the party who is to repay the relevant debt. 

Payee or lender – Include the name of the person or institution lending the money to the payor. 

Date – List the exact date the promise to repay is effective. 

Amount or principal – State the amount of money borrowed by the borrower. 

Interest rate – If the loan involves interest, the promissory note should include the simple or compound interest rate charged. 

Details of repayment – A common arrangement is to have payments due on the first of every month. Alternatively, if multiple payments are due, the promissory note should include how often payments will be made as well as the amount of each payment.

Signatures – For a promissory note to be legally enforceable, you must ensure that signatures of both the borrower and the lender are included.

Does a promissory note need to be notarized? 

A promissory note is a legally binding agreement similar in nature to any common law contract. Relevantly, in order for a contract to be enforceable, it must contain certain legal conditions such as an offer and acceptance. When all the terms and conditions stated above are addressed and it is signed by both parties, the promissory note becomes a legally binding contract, meaning that it will not need to be notarized in order for it to be effective. However, businesses may nevertheless choose to have promissory notes notarized in order to avoid potential disputes over authenticity even if the governing law does not require it.

Are promissory notes right for your company? 

For early-stage businesses in need of initial financing, promissory notes are an essential instrument in obtaining a loan from financial institutions or other investors. To protect your personal assets from the liabilities and obligations that arise from your company’s business activities, your business may choose to issue promissory notes in its name to lenders.

While promissory notes may appear simple and straightforward, understanding them and the different ways they can be used for you and your business specifically can be complex and time-consuming, especially during the early stages of its lifecycle. 

READ MORE: Five Clauses Every Shareholders’ Agreement Should Include.

DOCUMENT:  Loan Agreement

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