It's easy to see why small businesses rely on verbal commitments and informal vows when handling transactions. But just because it works now doesn't mean it could generate the…continue reading
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What Is a Promissory Note?
Records by Debt.org shows how American household debt reached an astounding 13.21 trillion U.S. dollars in 2018. It’s an alarming number that reflects the cause and effects of loans in today’s world. But considering the benefits offered by these loans, it only makes sense to make sure that these financial agreements legally seal the deal.
One of the most common types of commercial contracts made between parties is the promissory note. We define a promissory note as a written vow that reflects a party’s agreement to pay back money borrowed. It’s a binding agreement between two parties, namely the borrower and the lender, that helps formalize the loan for legal purposes.
If you want to lend a large sum of money to a person, putting it into writing gives the other the obligation to repay the loan within a specified period. Also known as a note payable, an adequately written promissory note may be enforced in the court of law to ensure that the parties involved reach a fair settlement by the end of the professional relationship. As long as those involved in the arrangement sign the note, you are each expected to uphold your end of the agreement to avoid legal problems down the road.
The Advantages of a Promissory Note
Promissory notes can come in handy in numerous settings. A promissory note for personal loans, student loans, business loans, vehicle loans, and mortgages are quite common in today’s world, as it allows borrowers and lenders to set the terms and details of the arrangement coherently on print. Given how an alarming 12.8 million bankruptcy petitions were filed between 2005 and 2017, as reported by the United States Courts, it’s safe to say people tend to hold onto loans to keep themselves afloat during trying times.
For lenders and borrowers, the promissory note guarantees that both parties follow a fair process in providing and acquiring these loans. Think of it like a legal contract that ensures that both parties stay true to their word. Other reasons why promissory notes to secure a promissory note include the following:
Types of Promissory Notes
There are two specific types of promissory notes: a secured promissory note and an unsecured promissory note.
Secured promissory notes are loans backed by collateral in the form of a house, a car, or any asset of significant value. If the borrower fails to pay the loan amount as promised, the lender has the right to take away the property as agreed in the promissory note. A lot of thought and planning goes into making these kinds of decisions, which is why it’s crucial to think twice before agreeing to the arrangement.
Unsecured promissory notes, on the other hand, do not involve a mortgage or deed of trust for security. Even then, lenders still have the authority to pursue legal action if the borrower fails to pay the loan amount on the expected due date. You can also opt to undergo a debt collection process to settle the case by filing a claim in the court of law.
How to Make a Promissory Note
Taking out a loan can be a scary thing, especially when you’re unfamiliar with the process. As a lender or a borrower, it is your responsibility to be aware of how these arrangements work to secure yourself from legal conflicts. Promissory notes spell out the details of the loan, particularly its legally binding components. Thus, a promissory note is only useful when it is written thoroughly.
If you’re new to this, understanding how promissory notes function and what it should cover is crucial to a safe and lawful arrangement. With that said, here’s a step-by-step guide for you to follow.
Step 1: Secure a Template
Promissory notes generally contain the same elements, all of which you will likely find in a ready-made template. But because every case is unique, you will have to customize the template to meet your exact requirements. Some promissory notes even come in the structure of a form that you could fill out with your personal information. Just be sure to find a note template that’s closely similar to your ideal content.
Once you find one, you can make the necessary adjustments in the succeeding steps.
Step 2: Identify the Parties
Name the parties involved in the arrangement, namely the party that lends the money and the party that receives it. You’ll also want to make sure that each party’s names and addresses remain clear and correct for proper identification. As for co-signers to the contract, be sure to indicate them as well. Don’t forget to write the date of the note in the upper part of the front page.
Step 3: Indicate the Borrowed Amount
Money—the most vital element of any loan agreement. Without any indications of the exact borrowed amount, creating a promissory note would be pointless.
Think about how someone would issue a check. The amount borrowed must be written in numbers and spelled out in specific detail, along with its currency. That way, there’s no way for a reader to misinterpret the promissory note. It’s also a smart way to prevent unauthorized alterations by either party. If you make even the slightest mistake, it would be much better to rewrite the note than to make messy changes to the document.
Step 4: Define the Payment Method
How and when the borrower should settle the payment is something to be negotiated before signing. Both parties must agree on the due date, the means of payment, and other alternatives should the first two be impossible to carry out. If you want the other party to make the payment in cash on a month-end basis, clarify this arrangement in the promissory note. This part of the agreement should explain how settlements will take place from when the first payment is due to when the final payment will be made. It’s always a better idea to provide specific dates as opposed to obscure timelines that may confuse those concerned.
Step 5: Specify the Interest Rate
Similar to the amount to be paid, you must write the interest rate in a numerical percentage and words. It is the amount charged on top of the money borrowed based on the lender’s conditions and the laws of the state. Keep in mind that most states provide an interest rate that banks and other financial firms must conform to in order to legalize the transaction. If applicable to your case, you must also state how you plan to integrate the interest rate into the final balance.
Step 6: Determine Possible Penalties for Late Payments
Although this is not something you’d find in most promissory notes, many lenders feel the need to define how late payments and penalties will be handled. For instance, if a borrower settles the payment only a few days after the specified deadline, will the borrower be charged extra as a penalty? Or will you provide a grace period as a chance for borrowers to settle their dues? Make sure to offer considerations for instances that go beyond either party’s control, as you wouldn’t want to make it hard for people to decide whether to accept the loan or not.
The Dos and Don’ts of a Promissory Note
You’ve probably heard about promissory notes being used in school to grant a student permission to take an important exam, despite failing to settle their academic fees on time. Promissory notes may also be used in various business settings and financial services to acknowledge basic payment plans between the lender and the borrower. As long as the note involves legally competent parties and a legal purpose, then you do have the authority to take the other party to court in the event of a dispute.
Since we’ve already covered the steps in writing one, let’s discuss the guidelines to keep in mind when preparing a promissory note.
1. Do look out for simple mistakes.
Even the simplest mistakes can make a massive difference in the outcome you were hoping for. Watch out for misspelled names, incorrect figures, and other errors that you must correct before signing. Double-check minor details that tend to get overlooked at the first read. You may want to gather other supporting documents for review to avoid discrepancies that could void the loan agreement. Otherwise, you won’t receive a fair trial, and you might as well bid your money goodbye.
2. Do read it carefully.
If there are parts of the note that don’t make sense to you, run through it with the other party, a legal expert, or even an accountant for better comprehension. You must pay close attention to default terms that play a crucial role in the agreement, including interest rates and payment terms. The last thing you’ll want to do is to get into a binding agreement for something you know little to nothing about. There could also be terms in the promissory note with seemingly vague definitions. In such cases, rewriting this part of the document may be necessary to avoid misinterpretation. Some details can be misleading if the author fails to define them accurately, which is why it’s essential to be wary of these instances to keep both parties on the same page.
3. Do keep it in writing.
As a lender, not having a written loan agreement will put you and your business at risk. Any disputes that arise will be impossible to settle without proper documentation. Thus, citing the terms and conditions of the arrangement in a promissory note may help remind each party of their obligation in the engagement for the benefit of all. It also sets expectations in which both parties must uphold to avoid any issues. Whether it’s a secured promissory note or an unsecured promissory note, be sure to have it in print. It must also cover all the essential bases to make it official.
1. Don’t lose the original copy.
Whatever you do, try not to lose the original copy of the promissory note. Upon signing, each party should have their own copy of the document for proof and reference. Over the years, there have been cases of sudden alterations made to the agreement without the other party’s knowledge, and this often happens when you produce only one copy of the promissory note. Although it’s unlikely you’ll encounter this with a well-established financial firm, it’s still something to look out for, whether you’re a lender or a borrower. Each party may face multiple consequences caused by this mistake.
2. Don’t modify the note without undergoing a legal process.
If you wish to modify the promissory note after the initial signing, make sure that all parties involved agree to it first. For example, the borrower might want to extend the payment deadline in exchange for an increase in the interest rate. You must run this over with the other party as a proposal to determine whether these changes are necessary to the case. Keep in mind that even the slightest alterations in the note may affect the factors leading to the final payment amount. Without getting the greenlight beforehand, the other party will likely refuse to sign the agreement, making it unenforceable.
3. Don’t forget to run it over with your attorney.
You might have heard this a million times before, but it’s worth emphasizing all over again. You’re about to sign a legal document that will bind you to an agreement for quite some time, so to spare you from any costly catastrophes, seeking legal advice from an experienced attorney is highly advisable. This is an opportunity for you to raise questions and concerns about the promissory note that confuse you. Legal advice is crucial in this setting, especially if you aren’t too familiar with how it all goes down. If you don’t understand what’s stated in the promissory note, don’t sign it. Always have it clarified by an expert before jumping in.
Protect your legal rights with the help of a carefully written promissory note. Because these financial instruments can serve as legal proof of a loan, these documents must be appropriately drafted to avoid trouble with the opposite party and the authorities. It’s always a good idea to educate yourself on the laws and regulations of enforcing these legal agreements before using it for any desired purpose. But if you find yourself in urgent need of a promissory note, feel free to download the promissory note templates and samples available for your convenience. Remember never to sign the document unless you’ve had it reviewed by an expert.