Promissory Note vs. Loan Agreement

You’ve likely used a simple document to borrow money from friends or family members, such as to buy a car, even if you have never taken out a loan from a big financial institution. You may have borrowed money from your parents to buy your first house and memorialized the terms in a written contract.

Promissory notes and formal loan agreements are the most common agreements concerning money borrowing and repayment.

The loan agreement and promissory note are two types of loan documents. What are the similarities between these two types of documents? Find the differences between promissory note vs. loan agreement, and the similarities are here.

 

Loan Agreements: What Are They?

An agreement describing the terms and conditions of a loan is known as a loan agreement. It should be used when significant amounts of money are involved, especially for lenders and borrowers who are not very closely associated or wish to maintain a formal approach. Small businesses, including corporations, partnerships, limited partnerships (SLPs), and sole traders, should use this agreement.

In a loan agreement, the principal terms include the loan amount, repayment date, agreed-upon installment dates, and interest due.

Borrowers can also add security to a loan by pledging assets as collateral for the loan. You should consult a lawyer before entering any secured loan arrangement since some issues are complex.

It follows the general rule that loan agreements have four sections. The circumstances of each loan are unique, but the four sections remain the same.

 

Defining & Interpreting

A dictionary in this section defines all the jargon used throughout the loan agreement, including domain-specific and unusual terminology unfamiliar to an ordinary person.

 

Financial / Commercial Information

There are three sections in this section:

• The total amount of the loan.
• The amount to repay.
• The date by which it is to become due.
• The interest charges apply to the loan.

It is a strict follow-up on the dates in this case, as opposed to the promissory note, which is more tentative and negotiable.

 

Details of the transaction

Detailed information about this transaction appears in this section. This includes information about the borrower’s identity, as well as his personal information. Additionally, this chapter discusses in detail the case where the borrower fails to pay the given amount as expected.

 

Loan Agreement Types

During the final section of the loan agreement, all clauses stated throughout the complete document are clearly outlined.

In addition, people use two main types of loan agreements. First, unsecured loan agreements do not offer security if the borrower defaults or does not return the money. As a result, the lender cannot do anything, and the loan agreement will not help him recover the money.

Nevertheless, a secured loan agreement is a more reliable type of loan agreement. If the borrower cannot repay the loan within the agreed-upon date, the lender can legally seize the borrower’s assets.

 

Promissory Notes: What Are They?

The promissory note is a document with agreed-upon terms whereby one party lends money to another party with agreed-upon terms. With both parties’ agreement, the amount or duration of the return can be changed over time through the negotiation of the document, meaning that the amount can change over time.

As the name implies, it is a promise to pay back some money to someone you lent. A variety of names may know it. It may also be called Payment on Arrival, Payment on Demand, or IOU. However, the main procedure is always the same. It is important to note here that promissory notes are mainly used for a small number of loans since it is not a formal method of obtaining them.

Promissory notes have the following major components:

1. Borrower’s loan amount.
2. Date of maturation.
3. (If applicable) Interest rate.
4. Late payment penalty.

It is important to note that the above format can vary from note to note and dramatically varies by the parties. Generally, promissory notes follow the following format. However, they may skip some of the above sections if the parties intend to have a relatively informal note and the amount isn’t that large.

 

What Are the Benefits of Using a Loan Agreement?

It would help if you used loan agreements when you want to borrow a large sum and you also want to use them. If you cannot trust the other party, you cannot trust them personally. It is easier to sit back and relax using a loan agreement instead of a promissory note because you won’t have to worry about your money. Whatever happens, you will always receive your money back.

 

 

If you want to lend money to a relative who wants to buy a car or house, you must ensure your money is secure. For instance, he wants to buy a car or a house. In this case, the amount of money is quite large, so you need to ensure it is secure. The loan agreement makes sense since a promissory note would be hazardous here.

 

Using a Promissory Note in Certain Situations

There are a lot of cases where promissory notes apply, as long as the sum of money isn’t too big. Furthermore, the money is a loan to someone close to you, such as your cousin or relative. Despite having some trust between you and the other party, you don’t want to enter into a legal agreement since you know that, regardless of what happens, you’ll get your money back eventually without any legal agreement.

The flexible routine of return is another time when you can use this. There is a possibility that the date when you are supposed to get the money back isn’t final. Since the promissory note isn’t a legal contract, the parties can change the dates or regular installments with mutual understanding.

 

How Do Promissory Notes And Loan Agreements Differ?

Now that we know their similarities let’s discuss the differences between these two documents. It is typically used for more informal relationships to use promissory notes (but not always).

It primarily serves short-term, small loans between friends and family rather than longer-term, formal loan agreements. A large bank or other financial institution usually has specific loan documents for specific situations they use to lend money. Loan agreements cover everything from vehicles to mortgages to launching new businesses.

It is generally not formal to use a promissory note.

 

A promissory note does not bind the lender.

Unlike promissory notes, loan agreements bind the lender as well, as the lender also signs a loan agreement, while a promissory note does not.

Although the lender signs a loan agreement, they rarely bind themselves to anything. The word “bind” may not tell the whole story. Instead, the loan agreement will give many details about the lender’s rights.

Unlike the borrower, the lender does not usually promise to do something but acknowledges the loan and their rights, which often include what they can do if the borrower doesn’t pay and their dispute resolution options.

 

There is generally a lot more complexity to loan agreements.

A loan agreement is usually longer and more complex than a promissory note because large, complex loans need concrete terms. Several form clauses have been developed by attorneys over many years for most financial institutions in their loan documents, honing the requirements for loans and adding additional information as circumstances require.

Generally, loan agreements are usually more complex than promissory notes, but that is not to say promissory notes cannot be complex. Loan agreements are typically more complex than promissory notes.

 

How Are Promissory Notes And Loan Agreements Similar?

While promissory notes and loan agreements differ significantly, they are fundamentally similar.

 

They both refer to a debt to repay.

People often refer to these two documents interchangeably because they refer to money that has been loaned and needs to go back. Loan agreements are sometimes referred to as “notes” by large financial institutions.

Using either of these documents to repay money is legitimate, even if it is a significant amount. But, how these documents differ makes using either document slightly more transparent.

A promissory note or loan agreement describes the borrower’s obligation to pay the lender.

 

It is common for both to cover the consequences of non-payment.

Including information in a promissory note and loan agreement about what should happen if the borrower does not repay the lender is essential.

With this critical information omitted, neither document would be helpful! In the case of non-payment, the lender would only have recourse to take the borrower to court and argue about the consequences if the contract simply stated that the borrower would have to repay a lender with a certain amount of money.

To minimize the risk, the borrower should clearly understand the consequences of not paying within the confines of the document.

This does not mean that people do not go to court for unpaid money; people do this all the time. Nevertheless, since most of these documents contain provisions about penalties if the borrower does not pay, the lender has a much stronger case.

Both promissory notes and loan agreements usually contain information about what happens if the borrower fails to repay the lender.

 

There is a bond between them both.

In the same way that neither document would mean anything if it did not include information about consequences, neither document would mean anything if neither document binds the borrower.

A binding is a legal agreement binding a party to a particular act. Currently, the borrower is legally bound, and he has to repay the loan. The borrower is bound to pay back terms under a promissory note or a loan agreement. The borrower executes or signs both documents.

 

Factors to Consider

Some people may want a much simpler document than a promissory note. An IOU is usually a very informal document stating that one party owes the other money. An IOU often does not include non-payment consequences, making it an excellent document to prove a small, simple loan.

A mortgage, for example, is a particular type of loan against collateral (the house) that serves specific purposes. As mentioned above, a mortgage agreement is more specific than a standard loan agreement and should cater to its purpose.

 

Is It Better To Use A Loan Agreement Or A Promissory Note?

A loan agreement or promissory note outlines the repayment terms of debts and is legally binding. A loan agreement, however, usually contains more specific and stringent terms and more outstanding obligations and restrictions on the borrower. Additionally, security often comes with the loan (for example, putting up a house as collateral), whereas a promissory usually does not.

A promissory note is generally sufficient if the amount of money is relatively small and there is a great deal of trust between the lender and the borrower (or debtor). In contrast, a loan agreement is more appropriate if the two parties do not know one another well and have substantial debt.

 

Key Takeaways

Promissory notes and loan agreements outline a debt, but each suits different circumstances. A promissory note is a convenient way to ensure a paper trail whenever you lend or borrow a small amount of money, especially from someone you know.

In contrast, a loan agreement is more complex and often used for loans with substantial amounts of money at stake. Your circumstances, however, will ultimately determine which document is appropriate. Get the assistance you need with drafting a promissory note or loan agreement by contacting Attorney Real Estate Group.