A promissory note is a basic lending document that can be used in many business and personal situations. It’s basically a promise to pay. This note is a legal contract and it’s governed by the laws of the state where it’s written.
Promissory notes can be used in the following business or personal situations:
- For purchase of items like a car, furniture, or electronic equipment.
- For a business startup, for items like inventory or retail fixtures.
Before You Create a Promissory Note Form: Check These Laws
State lending laws. States regulate commerce, including the providing of notes and loans. Interest rates and usury limits are set by state law. Usury limits are maximum interest rates states allow to be charged.
Federal creditor protection laws. Several federal laws protect borrowers from unfair practices. In particular, check the terms of the equal credit opportunity law and the fair debt collection practices act. You will need to know these laws if you have to collect on a promissory note or if you charge interest.
What Makes a Promissory Note a Legal Document
To be sure your promissory note form is legal, it must have three things:
- Specific identification of the two parties––the borrower and the lender
- Specific identification of the amount to be borrowed
- Signatures of both parties
It is usually not necessary for a notary public to verify the signatures of the borrower and lender, but it’s always a good idea as extra protection for both parties.
If you want to be able to take the borrower to court if they don’t pay on the note, be sure that:
- Both parties are legally competent––neither is a minor, or under the influence, or mentally incompetent
- There is nothing illegal about the contract––it’s not a contract to borrow money to buy illegal drugs, for example.
Promissory Note vs. IOU or Loan Agreement
A loan agreement is a more detailed document for a more complicated transaction between a borrower and lender. This type of agreement might be used for the sale of a business.
An IOU (I Owe Unto) is an informal loan, written and signed, for a specific sum of money. Often, there are no payment terms. It may be legal but it’s not as detailed as a promissory note.
How a Promissory Note is Secured
Most promissory notes require some kind of collateral as security, in case the borrower doesn’t pay. Collateral is something of value that can be used to pay the loan. For example, a title to a car is considered collateral, and the title is held as security by the lender.
Security isn’t required, but if there is no security, the lender will charge a higher interest rate and it may take other legal measures to get money (usually in bankruptcy) if the borrower doesn’t pay back the money.
Lender vs. Borrower: Things to Consider
If you are the lender on a promissory note,
Check the borrower’s credit first. Lower credit scores should have higher interest rates.
- Always attempt to get security (collateral). While you can charge higher interest on an unsecured note, it’s more difficult to get your money.
If you are the borrower on a promissory note,
- Check to see if you must pay interest on late payments. This can increase your cost of borrowing if you don’t keep your payments current.
- If the note is for business purposes, make sure that the borrower is the business, not you personally. You don’t want to have to pay the debt yourself if the business can’t pay.
Sections to Include in a Promissory Note Form
Include the date the promissory note is effective.
Identify the parties. Specifically identify the borrower and lender, including names and addresses. You want to be sure (a) that the parties to the contract can only be these people and (b) that they can be found if necessary.
If there is a co-signer on the promissory note, that person or business must also be identified, and, of course, sign the document.
State the amount being borrowed. The amount being borrowed is a specific amount. State that it’s in U.S. dollars, or other currency if that’s the case.
Describe how and when payments must be made. What day of the month? You may want to specify that payments be made in cash. What happens if a check bounces?
Include the interest rate. Make sure the rate is within your state’s limits, as noted above. Also state how the interest rate is applied on the outstanding balance (whether it’s applied daily, monthly, or otherwise).
Describe late payment and penalties. When is each payment due? What happens if a payment isn’t made? Is there a grace period? For example, if a payment is due on the first day of the month, are there a few days after that when payment can be made without penalty? If interest is charged on late payments, specifically describe the rate, how and when interest is applied.
You may charge interest on the loan amount, or you may charge interest on late payments. Be careful not to exceed the usury limits in your state.
Describe the security on the note, if there is any. This description should be as specific as possible, so anyone could identify this property and use this information to find it. If the note has co-signers, make clear which one of the signers owns the collateral.
Describe what happens if the borrower defaults on the loan. When is the loan in default? What happens if the loan isn’t paid back?
Getting Help with a Promissory Note
A promissory note form may seem simple, and you may be tempted to use a promissory note form template from an online source. Read about why “free” online contract forms are dangerous
Every situation is unique, and laws and regulations change frequently. It’s always a good idea to have an attorney review your promissory note form before you sign it.