A Promissory note, or, more formally, a Note Payable, is a legally binding contract between a party who has borrowed money (the borrower) from another party who has lent the money, “the lender” with the promise to pay the lender back. While these agreements are usually personal or frequent in small business transactions, they are also useful in instances where the borrower is making a big purchase and is unable to pay the full cost at the time of the purchase. As such, the lender will offer to pay the outstanding amount with consideration that the borrower promises to pay the remainder at a later date. The nature of a promissory note is synonymous with an IOU.
Similar to a loan agreement, a promissory note typically specifies the principal loan amount as well as the interest rate and the expected date the payment of the outstanding balance should occur (maturity date). Not all promissory notes have a date of maturity. For example, a Demand Promissory Note stipulates that the lender can demand that a borrower repay his loan when the lender makes that request. With this method, the borrower may not necessarily have sufficient notice to repay. It is common for lenders to demand payment within a few days. When this is the case, the Demand Promissory Note may also include a clause indicating a grace period. Should the borrower be unable to repay the lender upon demand, the lender might contract for a five-day grace period allowing the borrower a little more time to fulfill his promise to pay, for example.
Though easily construed as the same, a promissory note and a loan differ on the basis that a loan agreement engages more detailed clauses to canvas a wide range of scenarios. Furthermore, promissory notes provide the lender with greater flexibility in drafting and construing the terms of the agreement. For example, if the lender does not wish to charge any interest he is not obligated to do so. Should he choose to charge interest, however, the interest should be reasonable. Interest rates on promissory notes can later be assessed by the federal or provincial government and the lender and borrow can face tax consequences where the rates are deemed unreasonable.
Another example of the lender’s discretion with respect to a promissory note includes the issue of security/collateral. A lender does not have to take security or collateral measures to ensure the borrower will fulfill his promise to pay. However, if the borrower defaults on his promise to pay pursuant to the contract, the lender has the option to take legal action to manage repayment. In addition, a promissory note is executed solely by the borrower’s signature. A loan agreement must be executed by both the borrower and the lender.
It is always in the parties’ best interest to act in accordance with the terms of a promissory note. Because it is a legally binding interest, any default in payment can be applied to the borrower’s credit record. Further, the lender has the right to take legal action for failure to comply with the terms of the note or a breach of contract in any capacity. As promissory notes are, in large part, drafted at the discretion of the lender, it is wise to draft the note with sufficient protection in conjunction with the lender’s interest.
A promissory note is still a reliable method to facilitate financial loans, but its effectiveness comes down to how well the terms of the note are written and construed.