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4 Types of Promissory Notes and When To Use Them

Promissory NotesAt some point, you may need to ask friends, family, or a commercial lender for a loan. Or, a friend or family member in need may ask you to lend them money to make payments on their car. The reasons for seeking a loan can range from convenience to financial hardship. In order to fully protect your interests in your receipt or issuance of a loan, legal documentation is important. Acquaint yourself with four situations where you may need promissory notes and save yourself from future headaches and even litigation.

What is A Promissory Note?

A promissory note is a written document officially recognizing a legal relationship between two parties – a lender and a borrower. Promissory notes create a legally binding promise with a mutual understanding regarding the borrowing and repayment of money.

A comprehensive and thorough promissory note should address six simple questions:

  1. Who the parties are
  2. How much the loan is for
  3. How you will repay the debt
  4. When the debt must be repaid by
  5. What happens if there is a default in payment
  6. Miscellaneous provisions

Promissory notes are invaluable legal tools to bind other individuals to an agreement for goods or money; they carry the full weight of the law and are legally binding on both parties. Use promissory notes in routine and straight-forward contractual relationships between parties to avoid costly legal expertise. Next time you are entering into an agreement for goods or money, turn that handshake and bar napkin into a legally enforceable promise with a promissory note.

But, how is this different from an IOU or a Loan Agreement?

Think of IOUs as your standard “bar top promise,” scrawled on a napkin, kissed with lipstick, and barely legible. IOUs are informal and flexible. However, they carry no legal weight in a court of law. IOUs are the least protective of all notes and agreements, while loan agreements carry the most weight and are legally enforceable. Loan agreements are used for complicated repayment arrangements offering legal recourse (foreclosure) for a lender, should a borrower default.

So you’re probably wondering where a promissory note fits in? It’s right in the middle. Promissory notes are legally binding, however, they fail to provide remedies and recourse for a non-defaulting party.

When to Use Promissory Notes

  1. Installment Payment

When to Use One? Installment payments are commonly used when you are looking to purchase expensive items. Such items may include a new refrigerator, stove and other appliances.

Pros: When repaying the loan, payments are divided up into equal monthly payments (the installments), along with interest. It is discharged only after the principal balance has been repaid. Borrowers usually put up a “down payment,” or a fixed sum of money upfront, to reduce the amount of interest due. Installment payments allow for flexibility through gradual repayment of the debt or loan. This allows you to customize and adjust the repayment to your income.

Cons: Installment payments are usually subject to high-interest rates, increasing the sum of money you will have to repay. Lenders often disallow prepayment of loan balances, capping the amount you are able to pay back per month.

An installment payment would be useful for making a $150 monthly payment on a family car to get the kids to school everyday in. $50 of the payment goes towards the outstanding principal, while $100 goes towards the interest. Ultimately, $150 will be due on the maturity date (when it’s time to pay the entire amount).

  1. Installment Payments with a Final Balloon Payment

When to Use One? In the case of mortgage loans, use balloon payment notes. Short-term borrowers typically use balloon payment notes because they favor borrowers who are short on cash at the start, but are expecting to refinance or pay off the loan in the future.

Pros: Dissimilar to traditional installment payments, balloon payments boast lower interest rates. The trade off? For a lower interest rate, the borrower repays the principal and interest in consecutive, equal installments. And, at the end of a specified period, the borrower has two options. They could “reset” the loan (sometimes at the expense of a higher interest rate), or pay off the remaining balance (the balloon).

Cons: Keep in mind that balloon payments can carry extra risks. Oftentimes, borrowers will take out a new loan in order to pay the balloon payment. Doing so is a gamble. You gamble that interest rates will stay the same or lower over the payment of the loan. In regards to assets, you are gambling that the asset will not depreciate and become worthless.

  1. Due on a Specific Date

When to Use One? Due on specific date (DOSD) promissory notes are straight-forward and true to their name; they require the repayment of a loan or debt before a certain date. A good time to use DOSD promissory notes are for small amounts of money. For example, you could likely use a DOSD when you loan a friend $150 for the purchase of a new bicycle or minor car repairs.

Pros: With a DOSD, you don’t have to worry about a borrower defaulting on monthly payments, as there is a fixed, definite date of repayment for the loan and interest. Immediate legal action can be brought against borrowers by the lender.

Cons: A fixed date of repayment can create issues for borrowers who are insolvent and unable to repay the debt when the date comes. This can result in hassle and uncertainty when negotiating additional arrangements for repayment.

  1. Due on Demand or Default

When to Use One? Use due on demand or default promissory notes between friends and family or other informal relationships. A due on demand or default promissory notes would be best suited small loans, such as one for your sister’s small business, or nephew’s first car.

Pros: They are a “pay when you can” type of note, with no concrete repayment date. This allows borrowers to make good on the loan when they are financially able. Flexible lending and repayment can allow you to skip traditional, drawn-out, lending processes, and both notes usually offer no or low interest rates.

Cons: Even strong foundations of trust are susceptible to abuse. Trusted friends and family may take longer than expected to repay the debt and may take advantage of your good nature. Only use this style of promissory notes where there is a strong foundation of trust between lender and borrower. This way, there is no hurry for repayment.

Here are a few common situations where a borrower default occurs:

  1. Borrower fails to make any payment or pay any obligation when due under the note
  2. The borrower becomes insolvent
  3. The borrower files for voluntary bankruptcy petition or has an involuntary petition filed against them
  4. Borrower makes a general assignment for the benefit of creditors
  5. Lender or holder discovers misrepresentation was made to the lender by the borrower or on the borrower’s behalf, and absent misrepresentation, lender would not have entered into the transaction.

Familiarizing yourself with four types of promissory notes and when to use them has many benefits. First off, promissory notes can save you from loss of friendship and familial trust. They can also save from expensive legal fees and future litigation over recovering property and debt collection. So, memorialize your next money loaning agreement with a promissory note. Hopefully, this way your Uncle Donny doesn’t end up in a wheelchair with two broken legs after failing to pay off his bookie.

Guest Author:

Stock photo of woman looking sidewaysRachel Ryan a legal writer for LegalTemplates.net. Rachel specializes in providing professional, diverse and creative articles, equipping individuals with the perfect tools for a variety of legal issues. When she’s not writing awe-inspiring content, she can be found trying to become the next Martha Stewart.

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