What is a Promissory Note and When to Use It

What is a Promissory Note and When to Use It?

A promissory note enables an individual (‘the issuer’) to promise, in writing, to pay a certain amount of money agreed upon with another person (‘the payee’). Although a promissory note is an easy and equal instrument, it cannot be used in every situation where you borrow or lends money. It is also not to be mixed up with a loan agreement.

What Is a Promissory Note?

A promissory note is essentially a written promise by the issuer to pay a certain sum of money to the payee under certain conditions. This payment can be made on demand or based on a future date. Promissory notes are useful when the parties involved have a good, close and trust-oriented relationship and they deal with relatively small sums of money. In these situations, the parties might prefer not to negotiate a long and complicated loan agreement.

For instance, if John loans Jessica $ 1,000 and they do not engage in the process of negotiating a formal loan agreement, they opt for an informal arrangement. For Jessica to provide John with written assurance that the $1,000 will be repaid, so she issues a promissory note to Hailey. This note reveals Jessica’s intention of paying up the $1,000 as soon as possible and provides a written proof for the agreement between them.

Promissory Note Key Terms

A promissory note is a concise and straightforward document outlining essential terms, including:

  • Identification of the parties involved, indicating those committing to return the money and receiving back the repaid amount.
  • The amount should be repaid by the specified date.
  • Clarity on whether any interest would be due on the amount in question.
  • Determination of whether the promissory note is transferable to another party.
  • The signature of the person issuing the promissory note.

Promissory Note vs Loan Agreement?

Although promissory notes and loan agreements are issued in situations that involve one person borrowing some money with the intention of repaying it later, they are quite different.

A promissory note is much simpler than a loan agreement.

For instance, a promissory note does not need to be signed by both the borrower and the lender while taking loan agreements.

A loan agreement also provides the lender with greater protection and contains far more complex terms, such as:

  • The conditions under which and the time during which the borrower will obtain the loan.
  • The conditions that need to be met by the borrower.
  • More sophisticated repayment schedules (e.g instalment payment);
  • The representations and warranties made by the borrower;
  • “Default” events that would make the loan due and payable upon occurrence.
  • Commitments by the debtor, such as promising to adhere to relevant laws.

A promissory note may not be adequate in situations where you are:

  • Engaging with an unfamiliar party.
  • Lending a large amount of money.

In such situations, you might want to add the extra security and clarity given by an extensive loan agreement.

Key Takeaways

A promissory note is a simple document that proves beneficial in situations where:

  • You undertake to pay a relatively small amount of money.
  • This is a low-risk transaction.

However, promissory notes do not have much coverage for the creditor. Therefore, in situations where heightened protection is needed, it is worth opting for a full loan agreement. However, there is a need to note that the addition of more complex terms in a promissory might make it an intricate financial product and might place it under specific regulations such as Corporations Act or National Consumer Credit Protection Act. In such situations, it is recommended to consult a lawyer to check through the promissory note and establish its suitability for your particular situation.

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