How to write a promissory note?
Do you have a business that needs investors? Then a promissory note is something you need to know how to write and review.
A well-written promissory note means a well-polished financial business agreement.
As a small or established business, whenever you need to take a loan, the lender may require you to review and sign a promissory note.
If you are lending money to a business, a friend, or a loved one, you may want to consider writing a promissory note.
This is to establish the terms and conditions surrounding the deal that is being signed by both parties.
A clear promissory note is important for a smooth financial deal. And in this article, we will be showing you all about how to write one.
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What is a Promissory Note
Before we dive into the ‘how’ let’s talk about what a promissory note is.
A promissory note is a written document that sets out the terms of repayment when you loan or borrow money.
That may include any source, including from a commercial lender.
You may have heard the word ‘IOU’ countless times, that is simply an informal way of referring to a promissory note.
It’s important to know the in’s and out’s of what a promissory note entails, so you’ll know how to structure it for your business.
Documenting the loan terms through a promissory note will help you take necessary legal action when there’s a breach in the agreement.
Many promissory notes include interest even though it’s not what makes the note legally valid.
Depending on the payment plan you decide to have with the other party, you can make the promissory note interest-free.
Or use a zero percent interest rate, or up to the legally allowed amount of interest in your jurisdiction.
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Why do You Need a Promissory Note
If you’re running a business then you should know that legal documents are extremely important.
A promissory note is written to guarantee that there can be legal action if there is a default on the loan.
The lender holds onto the promissory note until the loan repayment is complete.
In the case of a loan default, the promissory note can be presented for legal action to be taken.
Without it, you may not have legal recourse to attempt to get your money back.
For instance, if it is a mortgage promissory note a lender or financial institution holds onto until the mortgage is paid off.
In the event of a default, the promissory note gives them the leverage to foreclose.
Once paid off they will issue a release of the lien.
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Elements of a Promissory Note
To write a great promissory note, you have to know exactly what it entails.
A promissory note will always include the signature area for both parties and your names of course.
The signature is an acknowledgment of the terms and conditions surrounding the loan.
It signifies that both parties understand all that the promissory note entails.
The Lender/Borrowers Name and Contact Information
Without the name and contact information of both parties, the promissory note can be declared invalid.
This is the difference between an informal IOU and a promissory note.
The promissory note is more legally binding because it’s more structured and official.
Your name and address plus that of the borrower must be included in the note.
Apart from this information, the date and place of issuance should also be written.
A third party is always a great idea in any business transaction.
The witness is a neutral ground that stands to acknowledge the exchange between both parties.
Either a witness signs or you get a notary public signature/stamp or both.
This ensures that someone other than the lender and the borrower is aware of the loan and the conditions surrounding it.
And authenticates their identity and signatures.
The Loan Amount
The loan amount is also called the principal debt.
It is the total amount of money borrowed by the payor, the amount to be paid back over the loan’s life, plus any interest or fees.
The specific amount of money you’re giving out or receiving must be written clearly in the promissory note.
How much are you giving out? What date did you give it?
These are the questions that you must answer as you draft your promissory note.
The exact amount of money must be included in the note for future references.
If this isn’t done, the person that received the loan can deny the amount or forge something.
It prevents and protects both parties from either making up lies or behaving fraudulently.
All the Repayment Terms
This is an extremely important element of a promissory note.
It details the exact payment methods and explains how the loan will be paid back.
The repayment terms state clearly if the loan is to be paid back in installments, at once, or on-demand.
For example, some loans can be repaid in monthly installments, or at the request of the lender.
Or, it can be paid in a lump sum at a specific maturity date, or call date.
Based on how fast you want your money paid back, you can set up a repayment structure that features systematic payments.
Another way to do it is by setting up a repayment schedule on certain specific dates.
Either way, a repayment term is a very important feature of a promissory note.
Here are a few common examples of repayment plans that can be found in promissory notes.
Payment on Demand
A loan that has a payment on-demand promissory note has no specific payment date.
But the loaner has the right to demand repayment whenever he/she likes.
Usually, when the lender demands the loan, a specific payment date is set up for the repayment.
This gives the borrower enough time to make certain arrangements before the time specified.
This type of promissory note payment plan is common among friends, family members, and acquaintances.
It is more flexible but at the same time, it is enforceable legally. So it shouldn’t be taken lightly.
Balloon payment which has nothing to do with balloons by the way is a very considerate payment plan.
It’s when the borrower firstly pays you in installments and then completes the payment at a later date with a large sum.
For example, picture a scenario where you loan a family member the sum of $20,000 to start up a business.
The agreement is that the payment will be made in 12 months so you set up a payment of $840 monthly.
And a final balloon payment of $10,000 at the end of the specified time.
The monthly payment is to pay you off for the period when your family member gathers the lump.
This makes the final lump much more affordable in a way.
Paying in Installments
This might be the most common form of repayment.
It allows the lender to repay the loan in an affordable sum on the specified and agreed dates.
A promissory note that has an installment payment term will specify an amount of money that has to be paid back monthly.
It can also be weekly, yearly, or quarterly. It depends on what you both agree on and what you both like.
The payment will continue until the principal debt and interests are completely paid off.
This payment structure keeps the whole process simple for all the parties involved.
The interest rate can be easily calculated and all the terms are clearly stated.
The Repayment Deadlines
Every promissory note should have a timeline for repayment. Whether it’s years, months, or dates.
The repayment deadline is the specific date that you as the lender or the borrower agree for payment to be made.
The deadline specified can be as long as possible. Some promissory notes carry repayment deadlines of up to 10years.
Depending on how far you intend to stretch out the payment, your deadlines can be anytime you both agree.
The Interest Rate
Not every promissory note will have a specified interest rate. But typically the interest rate should be specified in the note.
This interest rate is the amount that the borrower has agreed to pay on top of the principal debt amount.
The interest fee is a fee the borrower pays the lender for borrowing him/her the money.
The interest rate can be charged either as a variable rate that changes within a specific time.
Or it can be charged as a fixed percentage of the principal debt.
Either way, both parties must agree to the interest rate and specify it clearly before the promissory note is signed.
Types of Promissory Notes
Secured Promissory Note
A promissory note is called ‘secured’ if it is tied to a particular property.
This type of promissory note is used mostly for car loans and property loans.
Nevertheless, it can work for any type of loan that involves a purchase of any item with the loan money.
In a business, a secured promissory note loan can be tied to the business equipment, cars, property, and any physical thing that’s important to the business.
For example, if you give your friend a loan to start up a laundry or dry cleaning business.
Let’s say your friend took the loan to buy industrial washing machines and dryers.
If you want the debt to be linked to the washing machines and dryers, you would go ahead and draft a secured promissory note.
If your friend defaults on the loan the secured promissory note gives you the power to take the washing machines and dryers.
You can sell the machines to get your money back.
To take action on a secured promissory note, you may have to involve other legal authorities.
In this case, you may need to file a notice with your local court.
This is so that they can put out the information of your interest in the equipment to other potential lenders.
A lawyer is necessary for situations like this to fully protect and enforce your rights.
Commercial Promissory Note
When commercial institutions are involved in a loan or borrowing process, that’s when a commercial promissory note is used.
Commercial lenders/institutions include banks and loan agencies.
The promissory note grants them the right to demand payment with interest at the agreed time.
Commercial lenders have the right to appoint a lien on any asset owned by the business.
That is until full payment of the borrowed amount is made.
To assign a lien is to lay claim on any property owned by your business as security until complete payment is made.
For example, a bank holds on to the papers and title of a house or places a lien against the property until the mortgage is completely paid.
Investment Promissory Note
This type of promissory note is often a substitute for business loans.
It is used in situations where a business needs to raise capital or make some important purchases.
A business investment is one risk not many are willing to take, for good reason.
Should you decide to invest in any business, an investment promissory note will reduce the risks.
How? The investment promissory note ensures that you as an investor receive a return on your investment over a specified period.
If the borrower defaults on paying the investment back, you have the right to take ownership of the company.
As long as you have your investment promissory note with all the specifications and terms of the investment, you have full rights to take ownership of the company when there’s a default.
There are also convertible notes which can be transitioned from debt to equity in a business should it perform well.
Would you like more details about what is a convertible note? Check out this video I have created where I explain in detail how that works.
Writing a Promissory Note: Conclusion
Once you decide on the type of promissory note you want to draft, then you can start writing.
To ensure your note is legally valid, you have to include all the necessary elements we have mentioned in this article.
Your promissory note should be clear, agreed upon, and professional.
The names and contact addresses of both parties should come first, they should be visible at the top of the promissory note.
The terms of the agreement/repayment; like the repayment plan, the interest rate, and the repayment deadlines should come next.
The signature of both parties which is the final seal on the document comes at the bottom or end of the promissory note.
Once both of you sign the promissory note, it will automatically become a legally binding document.
Ensure that every important element is included in your promissory note.
You should also have a good understanding of the terms surrounding the loan before signing it.
You can get a headstart and streamline the process by using a promissory note template.
Or having your attorney handle it for you.
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