Whether you are contracting to repay a small business loan with an investor or you have purchased a home, but are unable to make the complete payment for the renovations and repairs, business and personal loans can benefit from the legally binding power of a promissory note. A promissory note is a written promise between a lender and a borrower, in which the borrower promises to pay a stated sum to the lender at a specified date or on demand, in exchange for a loan. The adequacy of a promissory note however, largely depends on how well the document is drafted.
Preliminary, but necessary information
A promissory note is usually drafted by the lender, as he is more susceptible to risks, particularly when the borrower fails to repay the loan. When drafting a promissory note, it is pertinent to first identify the lender, the borrower, and the date the note is executed and takes effect. In some instances, the borrower’s address may be relevant for the purpose of collateral.
Once the parties to the note have been identified, the lender must outline the principal amount of the loan. This is defined as the amount of money the lender intends to loan to the borrower. The principal amount is not inclusive of any interest the lender may impose on the borrower. Further, the loan amount should be written in alphanumeric format with a currency notation to avoid any confusion.
When drafting a promissory note, the lender may determine the time length of the note. This is referred to as a term. A term can range from a month to a few years and in some instances, there are no specified dates; instead, the borrower must repay the loan on demand. A demand promissory note allows the lender to demand payment, giving the borrower a few days, usually, to initiate repayment.
Not all promissory notes require the borrower to pay interest. However, should the lender want to charge interest, the note should include the interest rate the borrower can rely on, for example, an annual rate of 8% for a one-year term. In addition, the lender should specify whether the interest would be compounded. In other words, how often will the interest rate be recalculated and added to the principal amount to derive a new outstanding balance. The more frequently the interest is compounded, the greater the interest the borrower has to pay.
There are multiple ways to repay the loan outlined in a promissory note. However, rather than leaving the borrower in the dark, payment expectations should be drafted in a promissory note. Payment options typically include a lump sum payment at the end of the term, an interest only payment, an interest and principal payment, or a specified amount. In addition, the method of payment should be verified as well (cheques, direct deposit, etc.)
When construing the payment clause, it is a good idea to also include penalty clauses at this point so the borrower is aware of the consequences for failing to pay the outstanding principal amount.
Depending on the nature of the loan, a lender might include a security clause to protect his interest and ensure the loan is paid. For example:
This note is to be secured by collateral:
The security is a 2017 Mercedes Benz
The VIN of the vehicle is 00000000000
If the lender wishes to add further clauses he may do so as well, so long as the clause is not deemed objectively unreasonable. Clauses that a lender may include in a promissory note beyond the above include severability and governing law.
Finally, once the promissory note has been drafted, it should be executed before a witness or a notary public (depending on the jurisdiction). In most cases, promissory notes are only signed by the borrower. However, should a lender wish to sign as well, he likely will not be met with any objection.