Sunday, August 7, 2011

What is a Promissory Note and Why Do You Need One?

A promissory note is a legal contract used to record details of a loan transaction between two or more parties. Promissory notes are used in a variety of financial and real estate transactions, as well as business and personal loans. Before signing any promissory note agreement, it's important to understand the different types of notes, how they are used, repayment schedules and legal terms.

Types of Promissory Notes:

Personal: One of the most common types of promissory notes are ones used to document personal loans between family members or friends. Although many people shy away from legal documents when lending money to personal acquaintances, a personal promissory note can prevent misunderstandings. Drafting a personal note payable demonstrates a good faith effort on behalf of the Borrower and offers a sense of security to the Lender. Personal promissory notes should clearly state the repayment terms, amount to be repaid, how much interest will be charged and what will occur if the Borrower defaults on the loan.

Commercial: When borrowing money from a commercial lender, a promissory note will almost always be required. Similar to personal promissory notes, commercial notes outline the repayment terms, payment amount and interest rate. Should the Borrower default on a commercial promissory note, the lender has the right to demand full payment. For example, if you take out a $5000 loan and default on it with a balance of $2500 due, the Lender can demand you pay the balance immediately. If the lender is unable to collect, they can place a lien on the property you are financing. If the lender sues you, they can legally take possession of your property. Not only will you lose the property, but it will also leave a negative impact on your credit report.

Investments: Many organizations use promissory notes as a way to raise capital for business. A promissory note is issued to investors in exchange for a loan. This type of note payable guarantees investors will receive a return on their investment within a specific time period.

Real Estate: Negotiable promissory notes are used in real estate transactions. Governed by Article 3 of the Uniform Commercial Code, real estate promissory notes must meet certain conditions set forth by the National Conference of Commissioners on Uniform State Laws.

Repayment Schedules:

There are several types of repayment schedules associated with promissory notes. Personal notes are usually more lenient than commercial, investment or real estate notes. Commercial lenders typically devise a repayment schedule based on financial forecasting. Basically, there are three types of promissory note repayment schedules. They include:

Installment Payments with Interest: This type of repayment schedule is referred to as amortized payments and allows Borrowers to pay a set amount each month for a specific time period. A portion of the payment is applied toward the principal and the remainder is applied toward the interest. This type of repayment schedule is common when borrowing money for an automobile, home or business loan.

Balloon Payments: This type of repayment schedule allows borrowers to pay installment payments or interest-only payments; followed by one large (balloon) payment at the end of the loan. Although interest-only payments can be appealing, the downside is the principal amount of the note never decreases. The balloon payment consists of the entire amount of principal, along with any interest remaining on the loan.

Lump Sum Payment with (or without) Interest: This type of repayment schedule is frequently used for short term personal loans which can be paid back within twelve months or less. As the name implies, the Borrower repays the amount of the loan in one lump sum payment on a specific date. If interest in charged the amount of interest should clearly be stated in the promissory note along with the principal amount and repayment date.

Legal Terms:

Although promissory notes are relatively simple documents, it's always a good idea to have an attorney draft them. At the very least, an attorney should review the documents to ensure they are legally binding and will hold up in a court of law. Should you decide to draft a promissory note without legal counsel, it's wise to be familiar with the terminology used within the document. Basically, there are five legal terms used in a basic promissory note.

Promisor - The person who is obtaining the loan and who will be obligated to repay it.

Promisee - The person who is providing the loan and who will receive payment for it.

Obligor - The person who is bound by the legal agreement; usually the Promisor.

Obligee - The person to whom the Obligee is bound; usually the Promisee.

Mutual Consideration - When there is a contract between two parties there must be some value received by both parties. This is referred to as "mutual consideration". In the case of a promissory note the Promisor receives value from the loan and the Promisee receives value from the repayment of the loan.

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