Promissory Notes & Loan Documentation

Promisory Note

Promisory Notes are one form of contracts. It is specific however as to an amount that one person agrees to pay to another plus interest. The Note may be sold or transferred to another by the payee (the person to whom payment is owed) .

The individual who promises to pay is the payor or maker, and the person to whom payment is promised is called the payee or holder. If signed by the maker, a promissory note is a negotiable instrument. It contains an unconditional promise to pay a certain sum to the order of a specifically named person or to bearer—that is, to any individual presenting the note. A promissory note can be either payable on demand or at a specific time.

If the Note is for personal or consumer purposes, special rules and consumer laws will apply. There may be limits on the interest rate level, terms of payment and there may be required consumer notices that are to be given.

Certain types of promissory notes, such as corporate bonds or retail installment loans, can be sold at a discount—an amount below their face value. The notes can be subsequently redeemed on the date of maturity for the entire face amount or prior to the due date for an amount less than the face value. The purchaser of a discounted promissory note often receives interest in addition to the appreciated difference in the price when the note is held to maturity.

When Should I Use a Promissory Note?

If you borrow start-up cash for your business from a commercial lender, the lender will require you to sign a promissory note. You should also use a promissory note when borrowing money from a friend or relative. Documenting the loan can do no harm, and it can head off misunderstandings about whether the money is a loan or gift, when it is to be repaid, and how much interest is owed. It also documents the terms of the loan in case the IRS comes sniffing around with a business audit.

Notes for business loans that are signed by the business will usually require personal guarantees.

A promissory note sets out the repayment terms when you borrow money. There are several ways to structure repayment -- all with advantages and disadvantages. It pays to learn the ins and outs of each repayment plan type so that you can choose the best method and terms for you.  There often are many terms that can be negotiated. Here are a few examples:

Types of Repayment Schedules

Banks provide their own promissory note forms. If you borrow from a friend or relative, you'll need to use a promissory note from form books or software. The legal and practical terms of promissory notes can vary considerably, but the most important thing is to pick a repayment plan that's right for you. Following are four different approaches.

Amortized Payments

With amortized payments, you pay the same amount each month (or year) for a specified number of months (or years). Part of each payment goes toward interest, and the rest goes toward principal. When you make the last payment, the loan and interest are fully paid. In legal and accounting jargon, this type of loan is fully amortized over the period that you make payments. (You've probably dealt with an amortized repayment schedule before, when paying off a car loan or a mortgage.)

Once you know the terms of the loan (the amount you want to borrow, the interest rate, and the time over which you'll make payments), you can figure out the amount of the payments using software  or an online calculator.

Equal Monthly Payments and a Final Balloon Payment

This type of repayment schedule requires you to make equal monthly payments of principal and interest for a relatively short period of time. Then, after you make the last installment payment, you must pay the remaining principal and interest in one large payment, called a balloon payment.

Because of the lower monthly payments during the course of the loan, you can keep more cash available for other needs. Of course, when you're thinking about those nice low payments, don't forget the big balloon payment waiting around the corner.

 Balloon payments can have extra risks. If you plan to take out a new loan when it's time to pay the balloon payment, you're gambling that interest rates will stay the same or go lower over the life of the loan. And if you're buying an asset (such as a building) that you plan to sell quickly to pay off the loan before the balloon payment comes due, you're gambling that the asset will not depreciate.

Interest-Only Payments and a Final Balloon Payment

With an interest-only loan, you repay the lender by making regular payments of only interest over a number of months or years. The principal does not decrease. At the end of the loan term, you must make a balloon payment to repay this principal and any remaining interest.

The obvious advantage of this arrangement is the low payments. And, if you find yourself in the happy situation of having extra cash, you can usually prepay principal. But over the long term, you'll pay more interest because you're borrowing the principal for a longer time. For instance, on a $20,000 loan, paid back in four years, you would pay almost $3,000 less by making equal amortized payments than if you made interest-only payments plus a final balloon payment.

Single Payment of Principal and Interest

Some loans, especially those from friends and family members, don't require regular payments of interest and/or principal. Instead, you pay off the loan all at once, at a specified future date. This payment includes the entire principal amount and the accrued interest. Borrowing money on these terms is best for a short-term loan, or if the lender isn't worried about on-time repayment. You are not likely to get this kind of deal from a commercial lender.

Read the Fine Print

No matter which repayment method you choose, be sure to read your promissory note and any other loan documents carefully. Promissory notes provided by commercial lenders in particular usually contain all kinds of legalese and scary waivers of legal rights.

One example: Make sure you can prepay the loan without paying a penalty -- some states allow a lender to charge you a fee (which is really designed to compensate the lender for the loss of future interest) for prepaying the loan

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