A Promissory note is a financial document in which a borrower promises to pay back a specified amount of money borrowed from the lender by a given due date. The promissory note outlines the terms of the loan, such as the principal, interest, loan maturity date, date of the loan, disbursement of funds, and signatures of the lender and the borrower.
Overview and Purpose
A promissory note is a written and legally enforceable agreement between a lender and a borrower. The borrower vows to pay the money specified in the promissory note within a timeframe, also specified in the promissory note. With the “promise” evident in writing, the borrower is held accountable for settling the debt. Even though less legally enforceable than a loan contract, it is more enforceable and more detailed than an IOU.
Promissory notes can either be secured or unsecured. They are used to assure the lender that he or she will receive his or her payment on the agreed date and terms. This is in a case where the borrower cannot raise the required full payment at that moment. A promissory note provides the necessary paper trail or documentation in lending and borrowing transactions which are necessary for tax purposes and reference.
Scenarios where a promissory note can be used, are as follows;
- Business loans – Most businesses have to operate on credit for their survival, for example, when restocking. Therefore, a loan can be useful to pay their suppliers before they can generate revenue from sales. A promissory note can be used to secure such a loan that is to be paid in the near future.
- Purchases –It can be used when someone wants to sell products or services to another person or entity that cannot raise the full purchase price at the moment.
- Real estate loans – Most people and entities will often acquire property through loans due to the high amount of buying property.
For example, a promissory note can be used when a seller wants to sell his property to a buyer who is not able to raise a down payment.
- Student loans – Student loan lenders can have students sign a promissory note when borrowing student loans for tuition and other educational needs.
- Personal lending – Sometimes, family and friends need some financial help from time to time. Whereas an IOU might suffice for small amounts of money. A promissory note is more legally binding hence effective when huge loans are involved.
- Car loans – There are times when people apply for loans with their cars as security. This is usually a less formal approach. A promissory note can be used in such a case to bind the borrower to the loan terms.
A promissory note can also be used for straightforward loans, the repayment plans and terms of which are not too complex.
A promissory note is alternatively referred to as;
- Debt Note
- Notes Payable
- Notes Payable
- Commercial Paper
- Demand Note
- Commercial Paper
- Demand Note
Promissory Note Types
As earlier stated, there two general types of promissory notes. Despite serving a similar purpose (promise of payment), they do so under different terms and conditions, as discussed below.
Promissory Note Forms By State
How a Promissory Note Works
A promissory note (loan agreement) is a legally binding document; with that regard, attention must be paid not just to its contents but also to its process. A promissory note will sometimes be as effective as prepared. Below are steps on how a promissory note works:
Agree to terms
The first thing one should do is have a meeting with the borrower to communicate or negotiate the term of awarding the loan. The terms of a promissory note (loan agreement) will vary depending on the lender and situation, for it is a readily customizable document. However, just like a standard contract, terms laid out in a promissory note (loan agreement) must be mutually acceptable. A standard promissory note (loan agreement) will typically have the following terms.
- The amount being loaned out
- Interest rate
- Late fees
- Terms of payment
- Default clause
Run a credit report
Next, once the lender has determined to loan the borrower under the agreed terms, they should take the initiative to perform a credit check on the follower. It can be detrimental to assume just because you know a person, it is enough reason to loan them money, especially a huge amount of money.
- Reporting agencies – One can use any of the available online agencies to perform a credit check. These sites give a comprehensive and reliable credit report.
- Authorization form – It is important to note that an authorization form is required before carrying out a credit check on another person.
Security and co-signers
If there are concerns over the borrower’s creditworthiness based on the credit report, asking for security or a co-signer should be the next step for the lender. In cases where the borrower has been found not to be financially capable of paying back the money, another party must be named as their guarantor and will assume responsibility to pay back if the borrower is unable to pay back. The co-signer must be financially capable and willing to fulfil this obligation.
Write the promissory note
Once everything has been discussed, agreed upon, and one is satisfied with all the aspects of the transaction, then they can proceed to write the promissory note (loan agreement). It contains fewer details and terms than a contract. The document should be signed at the bottom by both parties. Money can then be disbursed to the borrower. It is recommended that promissory notes for loans exceeding $10000 should be notarized.
Receiving the money
Once the due date(s) arrive, the lender should receive their money as stipulated by the promissory note (loan agreement). When receiving payments, three possibilities may come into effect; the full amount is paid back, late payments, or the loan is entirely never paid back. If the loan is accordingly settled, a loan release form is prepared and issued to the borrower as proof of fulfilling their contractual obligations. However;
- If payment is late, the lender is rightfully allowed to issue a demand letter to remind the borrower of the ramifications of their actions as per the promissory note (loan agreement). This will often involve awarding the borrower a grace period to pay or face the consequences.
- If borrowed money is never paid, the lender can justifiably claim ownership of offered security, provided the loan does not exceed $10000, which consequently requires legal action. However, if the loan was unsecured and was less than $10000, the lender can collect the dues through a small Claims Court.
How to Calculate Interests and Installment Plan
Borrowers need to understand what exactly they are paying. The fundamental payments evidenced in a promissory note (loan agreement) are as follows;
Total interest owed
It is important to state that the interest rate is not the interest owed. Instead, interest owed is the money cumulatively owed as a function of the interest rate and time.
Total interest owed = The amount lent multiplied by the annual interest rate.
Since this interest is representative of an annual amount, what does one do for payment periods shorter than a year? To find the interest owed for a duration lesser than a year, one divides the annual interest owed by the fraction of the year it will take the borrower to settle the loan fully. For example, if full payment will be made with a quarter of a year, the annual interest is divided by 4. If payment will take half the year, divide by 2 and so forth.
For example, if one lends a friend $10000 to be paid after 6 months (half a year) at an interest rate of 10%, calculations will be as follows.
Annual interest owed = $10000 multiplied by 10% or (1/10) to get $1000, which is basically 10% of $10000. Thus, the interest the borrower is expected to have paid after the 6 months will be equal to $1000 divided by 2. The cumulative interest owed will thus be $500.
Final payment amount
The next item to be determined is the total amount the borrower will have to pay. This is referred to as the final payment amount, which is given by;
Final payment amount = Money loaned plus (+) the interest owed.
Using information obtained from the example given under the heading “interest owed” for consistency, we can get the final payment amount.
For example, with a loan amount of $10000 and an interest owed of $500, the final payment amount will be ($10000+$500) = $10500.
Monthly or periodic payment amount
Alternatively referred as to as installments. This is the amount of money the borrower will be obligated to pay after every specified period. It is commonly monthly but can be varied as seen fit.
Monthly payment amount = final payment amount divided by the number of months it will take to pay back the loan.
To put into perspective, using the final payment amount determined and the payment duration of 6 months required to settle the loan. Therefore, the monthly payments shall be equal to; $10500 divided by 6 months, giving a monthly payment of $1750.
How to Write a Promissory Note
Coming up with an up to standard promissory note should be every lender’s objective. It might be the only way to receive money loaned. The systematic process outlined below is enough to come up with a professionally structured promissory note.
The first step in writing a promissory note is to write down the date when the promissory note was created. This date marks the day from which the document becomes effective. The date should show the day, month, and year.
Introduce the parties
Next, introduce the lender and the borrower. First, the promissory note, being a binding document, must clarify the parties bound by it.
- Lender – The lender is the party lending the money. Their official name and mailing address must be declared. The address should show the street, city and zip code, and state of their residence. He or she can also be referred to as the issuer.
- Borrower – The borrower is the party being awarded the loan. His or her official name should be provided together with their mailing address. He or she can also be referred to as the payer.
Also known as the principal is the amount that was loaned out. The exact amount to be paid back should be declared next. It should be inclusive of the interest, if applicable. The final due date of the loan should also appear in this section. Be specific as possible when stating dates.
The next item to write down is the payment plan. There are several distinct payment plan options available to choose from. The promissory note should state at this point the agreed-on plan.
- Lump-sum – A lump sum haves the borrower pay a single payment (principal and interest) that is due on a specified date.
- Installments – An installments plan sees the borrower pay periodic payments until the entire principal is fully cleared.
- Installments with final balloon – An installment plan with a final balloon payment allows borrowers to pay interest as periodic payments up to a given date when they are expected to make one last large payment(the principal amount) to clear the loan.
- Payable on demand – a payable on demand or due on-demand plan has no specific due date allowing the lender to demand payment at their convenience.
- Late fee – Borrowers can sometimes make payments days after the due date. To mitigate this, include a late payment penalty and declare the exact amount that will be charged.
Next, insert a default clause. The clause should state the consequences of defaulting and how the collection of the money shall be handled. Be sure to state the actions succeeding defaulting. Normally the lender can choose to issue a demand letter, initiate legal action, or take ownership of the asset offered as collateral. It should be clear how these probable actions are to follow each other. Also, expenses incurred when collecting defaulted loans should be billed to the borrower. The promissory note should indicate this.
As earlier mentioned, the promissory note can be secured or unsecured. Indicate if the promissory note is secured or not at this point. If it is secured, the valuable placed as security must be described.
If a co-signer was chosen as the best option for the lender to be cushioned in case the borrower fails to settle the debt, the co-signer should be identified by name. The obligations that shall befall them if the borrower cannot pay back should be outlined.
Indicate the state whose laws were observed in the creation of the promissory note. This is simply achieved by writing the name of the lender’s state of residence or where they are located if it is an entity.
It is recommended that the promissory note be notarized. The notary public should provide their name, signature, date of signing, and the county or state they represent.
Other details and clauses
A promissory note can include other clauses to cover concerns not addressed in it. Some of these clauses include;
- Acceleration – An acceleration clause allows the lender to demand the entire payment with immediate effect if the borrower misses payment or defaults without taking corrective actions. Other events that can prompt acceleration include the borrower’s death, bankruptcy, the borrower sells a big portion of their property.
- Amendment – An amendment clause outlines that changes to the promissory note must be done in writing.
- Collateral and insurance – A collateral and insurance clause allows borrowers to use different assets as collateral and permits the lender to seize the same if the borrower is unable to pay the loan.
- Joint and several liabilities – joint and several liabilities declare that any co-borrower shall share the responsibility for the loan payment as per the promissory note.
- Prepayment – A prepayment clause outlines the rules that are to be observed in case the borrower chooses to partially or wholly pay the loan. It will ordinarily request the borrower to pay a fee before prepaying.
- Right to transfer – A right to transfer clause allows lenders to transfer the promissory note and its rights and privileges to another party.
- Attorney’s fees and costs – An attorney’s fees and costs clause transfers the legal fees incurred by the lender in an effort to collect their money when the borrower defaults or misses a payment. The court can reverse this responsibility should the borrower beat the case.
- Waiver of presentments – A waiver of presentments clause protects the borrower by prohibiting the lender from demanding payment before the due date. The borrower is obligated to make payments as per the promissory note without being harassed.
- Non-waiver – A non-waiver clause protects the lender by pointing out that lack of or delay to exercise a right under the promissory note does not imply the lender is waiving their rights.
- Severability – A severability clause declares that just because a section of the promissory note becomes void or otherwise unenforceable, it should not translate to the voiding of the entire promissory note.
- Integration – An integration clause states that the validity is not dependent or affected by any other document, and the concerned parties must sign off any amendments to the promissory note.
- Conflicting terms – A conflicting terms clause declares that no other contract shall have greater legal authority about the loan or control the promissory note.
- Notice – A notice clause outlines how notices are to be handled, for example, means of delivery and other details like the number of days within which notice is to be issued and responded to.
- Execution – An execution clause reaffirms that the borrower is regarded as the principal in the promissory note and is majorly liable for all dues unless there is a co-signer who is legally equally liable for the same obligations.
The last step is having the involved parties sign the document. This includes the co-signer and witness (if any). Each party should provide their name, signature, and date of signing.
Usury Rate Laws
State laws limit how much interest rate can be imposed on borrowers. These state laws are known as Usury rate laws. The limits provided under different states are as given below.
|Arizona||There is no limit for loan agreements that are in writing. However, if not in writing, the interest rate shall be 10% per annum.||Ariz. Rev. Stat. Ann. § 44-1201|
|Alabama||A maximum interest rate of 8% for written contracts, 6% for verbal agreements.||Ala. Code § 8-8-1|
|Arkansas||The rate of interest may not exceed the maximum of 17% as established in the Arkansas Constitution, Amendment 89.||Ark. Code Ann. § 4-57-104|
|Alaska||For loans that are less than $25,000, the interest rate is 5% above the 12th Federal Res. District interest rate on the day the loan was made, or 10%, whichever is higher. For amounts greater than $25,000, there is no maximum rate.||Alaska Stat. § 45.45.010|
|Colorado||For supervised loans, the general usury limit is 45%, and the maximum for unsupervised loans is 12%.||Colo. Rev. Stat § 5-12-103 and § 5-2-201|
|Connecticut||The interest rate may not exceed 12%.||Conn. Gen. Stat. § 37-4|
|California||The interest rate may not exceed 10% annually on loans for personal, family, or any household purposes. For other loans for other purposes, the max is the higher of 10% or 5% over the amount charged by Federal Res. Bank of San Francisco at the time loan was made.||Cal. Const. Article XV, § 1|
|Florida||The general usury limit is between 18%, 25% on loans over $500,000.||Fla. Stat. § 687.03 and § 687.01|
|Georgia||The default is a maximum of 7% if no written contract is established. For written contracts, the maximum interest rate is 16% on loans below $3,000, 5% per month on all loans between $3,000 and $250,000, and there is no limit on loans exceeding $250,000.||Ga. Code Ann. § 7-4-2 and § 7-4-18|
|Hawaii||The default is interest rate is 10% if no written contract is established, 12% is the general usury limit, and 10% is the limit on judgments.||Haw. Rev. Stat § 478-2, § 478-3, and § 478-4|
|Indiana||8% interest rate in the absence of agreement, 25% for consumer loans other than supervised loans.||Ind. Code § 24-4.6-1-102 and § 24-4.5-3-201|
|Idaho||Unless stipulated in a written agreement, the max legal rate of interest is 12%. The max interest rate on money due or owed on court judgments is 5%, according to the law.||Idaho Code Ann. § 28-22-104|
|Iowa||The maximum interest rate is 5% unless it is otherwise agreed upon in writing, in which case, the maximum is set by the Iowa Superintendent of Banking (IA Usury Rates).||Iowa Code § 535.2(3)(a)|
|Kentucky||The max. legal rate of interest allowed is 8%, the general usury limit is 4% greater than the Federal Reserve rate or 19%, whichever is less. However, any rate may be charged/imposed when identified in a contract in writing for loans greater than $15,000.||Ky. Rev. Stat. Ann. § 360.010|
|Louisiana||The general usury rate allowed is 12%.||La. Rev. Stat. Ann. § 9:3500|
|Maine||The max legal interest rate is 6% (there is no usury limit mentioned in statutes in Maine).||Maine Rev. Stat., titl. 9-B, § 432|
|Maryland||The max. legal interest rate is 6%, a max. of 8% if a written contract is in place.||Md. Code Ann., Com. Law § 12-102 – 103|
|Massachusetts||The legal interest rate is 6% (unless there is a written contract that exists); even if part of a contract, a rate of interest over 20% is considered criminally usurious in Massachusetts.||Mass. Gen. Law Ch. 107, § 3, Ch. 271, § 49|
|Kansas||The legal rate is 10%; the general usury limit is 15%.||Kan. Stat. Ann. § 16-201 and §16-207|
|Minnesota||The max. legal rate of interest is 6%. However, for written contracts, the usury limit is 8%, unless for an amount over $100,000, in which case there is no limit.||Minn. Stat. § 334.01|
|Michigan||A 7% maximum rate if a written contract is established. Otherwise, the legal rate is 5%.||Mich. Comp. Laws § 438.31|
|Mississippi||The legal rate of interest is 8%. However, parties may contract for a rate of up to 10% or 5% above the Fed. Reserve discount rate of interest, whichever is greater.||Miss. Code Ann. § 75-17-1|
|Missouri||The maximum interest rate allowed is 10% unless the market interest rate is greater at the time.||Mo. Rev. Stat. § 408.030|
|New Hampshire||There is no legal limit on rates of interest. It is unclear/unspecified whether an exorbitant rate of interest could be considered “unfair” under the New Hampshire Consumer Protection Act and hence unlawful.||N.H. Rev. Stat. Ann. § 336:1, § 358-A:2|
|Nebraska||The maximum interest rate is 16%.||Neb. Rev. Stat. § 45-101.03|
|Nevada||Parties may contract/agree for a rate of interest up to a max. of 36% or the maximum rate permitted under the federal Military Lending Act.||Nev. Rev. Stat. § 99.050|
|New Jersey||6% in the absence of a written contract, 16% max. a Written contract is established.||N.J. Stat. Ann. § 31:1-1|
|New Mexico||15% max. in the absence of a written contract.||N.M. Stat. Ann. § 56-8-3|
|New York||The legal rate is 6%, the general usury limit is 11.25% (percent).||N.Y. Gen. Oblig. § 5-501 and N.Y. Banking § 14-A|
|North Carolina||For loans less than $25,000, the max. is the amount announced on the 15th of each month by the North Carolina Commissioner of Banks. For loans higher than $25,000, the parties may mutually agree in writing to any amount.||N.C. Gen. Stat. § 24-1.1|
|North Dakota||For any written contracts for loans lesser than $35,000, the maximum rate is 5.5% over the current maturity rate of Treasury Bills for the 6 months preceding the issuing of the loan, or 7%, whichever is greater.||N.D. Cent. Code § 47-14-09|
|Oklahoma||The parties may mutually agree in a written contract to any interest rate so long as it does not violate other applicable laws.||Okla. Stat. tit. 15, §266|
|Ohio||The max. interest rate for written contracts for loans of amounts less than $100,000 is an 8% rate of interest.||Ohio Rev. Code Ann. § 1343.01|
|Pennsylvania||For loans less than $50,000, the maximum rate is 6%.||41 Pa. Cons. Stat. Ann. § 201|
|Oregon||The legal rate is 9%, but the parties may agree to different rates in a written agreement/contract. Business and agricultural loans will have a maximum of 12 % or five percent greater than the 90-day discount rate offered for commercial paper.||Or. Rev. Stat. § 82.010|
|Montana||A max. of 15% or 6% above the rate published by the Federal Reserve System, whichever is greater.||Mont. Code Ann. § 31-1-107|
|Tennessee||The max. rate is 10% unless otherwise expressed in a written contract.||Tenn. Code Ann. § 47-14-103|
|Vermont||The rate is 12% except in specified circumstances as provided in subsection (b) of § 41a.||Vt. Stat. Ann. tit. 9, § 41a|
|Utah||The max rate of interest is 10% unless the parties mutually agree to a different rate in a written contract.||Utah Code Ann. § 15-1-1|
|Virginia||The legal rate of interest is 6%. However, with a contract in place, the maximum interest rate is 12% in VA.||Va. Code Ann. § 6.2-301 , § 6.2-303|
|Washington||The max. rate of interest is 12% or 4% points over the average bill rate for 26-week treasury bills in the month preceding the loan issuance.||Wash. Rev. Code § 19.52.020|
|West Virginia||The max. legal interest rate is 6%, but parties may agree to a maximum of 8% in a written agreement.||W. Va. Code § 47-6-5|
|Wisconsin||The legal interest rate is 5%. However, parties may agree to a different rate in a written agreement, subject to limitations that depend on the lender’s identity.||Wis. Stat. § 138.04|
|Wyoming||The rate of interest is 7% if there is no agreement is established in writing. Otherwise, parties may agree to a greater rate of interest.||Wyo. Stat. Ann. § 40-14-106|
Should I use a promissory note or loan agreement?
Whether to use a promissory note or a loan agreement will often depend on the situation. Promissory notes are more common among non-traditional lenders offering loans to individuals or entities with urgency for funds. Loan agreements are, on the other hand, used by traditional lenders for they are more detailed than promissory notes and are often associated with loans of huge sums of money.
What payment information is needed for the terms of a promissory note?
Generally, one will need to amount owed (principal), the loan interest rate, payment schedule, and preferred payment methods to be used by the borrower. In addition, one can include late fees for defaulters.
What is the difference or distinction between an individual and an entity?
Individuals and entities can be borrowers or lenders. An individual is basically a person where an entity is an organization or institution such as a corporation or LLC.
What information should I include about the borrower in a promissory note?
Primarily, the borrower’s name and mailing address are required. Additionally, their contact information such as phone number or email can be listed.
What are some of the tax benefits of a promissory note?
Lending money using a promissory note can benefit individuals as it can be used to enjoy certain tax deductions and exemptions. For example, the IRs permit annual gift exemptions of up to $14000 when gifting family members if a promissory note is used. However, this exemption is not included in the lifetime gift exemption of $5.45 million.
Can I sell or transfer my promissory note?
Yes. A lender can substitute a promissory note for money. This is as long as state laws have been observed and satisfied. Different states have different directives when it comes to determining if a promissory note is transferrable. It can be “payable to bearer” or “payable to order.”