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Main Findings
A promissory note is a written promise by one party to pay another party a definite sum of money, either on demand or at a specified future date. A promissory note typically contains all the terms involved, such as the principal debt amount, interest rate, maturity date, payment schedule, date and place of issuance, and issuer's signature.
A promissory note is a financial instrument that contains a written and signed promise between two parties to repay a sum of money in exchange for a loan or other financing.
A promissory note typically contains all the terms about the indebtedness, such as the principal amount, interest rate, maturity date, date and place of issuance, and issuer's signature. A promissory note is a legal contract that binds the borrower by law.
Promissory notes can be used for a wide range of loans, from personal loans to business loans, and can be either secured or unsecured. A secured promissory note describes the collateral—typically property—that secures the debt or amount borrowed. An unsecured promissory note doesn't involve collateral.
Promissory notes can lie between an IOU's informality and a loan contract's rigidity. An IOU merely acknowledges a debt and the amount one party owes another.
A promissory note includes a promise to pay on demand or at a specified future date, in addition to steps required for repayment (like the repayment schedule) Although financial institutions may issue promissory notes—for instance, you might be required to sign one to take out a small personal loan —they also allow companies and individuals to get financing from a non-bank source.
This source can be an individual or a company willing to carry the note (and provide the financing) under the agreed-upon terms. In effect, promissory notes can enable anyone to be a lender.
Why use a promissory note?
There are several reasons why someone might use a promissory note, such as:
To formalize a loan agreement and avoid disputes or misunderstandings.
A promissory note serves as evidence of the loan terms and conditions and can help protect the rights and interests of both parties.
To document the loan for tax and record-keeping purposes.
A promissory note can help the lender prove that the money was lent and not gifted and that they are entitled to collect interest income from the borrower. A promissory note can also help the borrower deduct interest expenses from their taxable income if the loan is used for business or investment purposes.
To obtain financing from alternative sources.
A promissory note can help individuals or businesses access funds from non-bank lenders, such as friends, family members, private investors, or peer-to-peer platforms. A promissory note can offer more flexibility and lower interest rates than traditional bank loans, depending on the creditworthiness of the borrower and the relationship with the lender.
Formula for calculating interest on a promissory note
The formula for calculating interest on a promissory note depends on the type of interest rate applied to the loan. There are two main types of interest rates: simple interest and compound interest.
Simple interest is calculated based on the principal amount of the loan, the annual interest rate, and the time period of the loan. The formula for simple interest is:
Simple Interest = Principal x Annual Interest Rate x Time
For example, if you borrow $10,000 at 5% simple interest for one year, you will pay $500 in interest:
Simple Interest = $10,000 x 0.05 x 1
Simple Interest = $500
Compound interest is calculated based on the principal amount of the loan plus any accumulated interest, the annual interest rate, and the number of compounding periods per year. The formula for compound interest is:
Compound Interest = Principal x (1 + Annual Interest Rate / Number of Compounding Periods) ^ (Number of Compounding Periods x Time) - Principal
For example, if you borrow $10,000 at 5% compound interest for one year, compounded monthly, you will pay $512.67 in interest:
Compound Interest = $10,000 x (1 + 0.05 / 12) ^ (12 x 1) - $10,000
Compound Interest = $10,512.67 - $10,000
Compound Interest = $512.67
How to calculate payments on a promissory note
The payments on a promissory note depend on whether the loan is repaid in installments or in a lump sum at maturity.
If the loan is repaid in installments, each payment consists of a portion of the principal amount plus interest accrued during the payment period. The payment amount can be calculated using an amortization table or an online calculator.
An amortization table shows how each payment is allocated between principal and interest over the life of the loan. It also shows the remaining balance of the loan after each payment. To create an amortization table, you need to know the principal amount, the annual interest rate, the number of payments per year, and the total number of payments.
An online calculator can help you find the payment amount by entering the same information as above, plus the payment frequency (monthly, quarterly, annually, etc.).
If the loan is repaid in a lump sum at maturity, the payment consists of the principal amount plus interest accrued over the entire term of the loan. The payment amount can be calculated using the formulas for simple or compound interest, depending on the type of interest rate applied to the loan.
Examples
Some examples of promissory notes are:
Student loans
These are loans that students take out to pay for their education. The borrower promises to repay the lender (usually the government or a private institution) with interest after they graduate or stop attending school. Student loans may have different repayment options, such as income-based repayment or deferment.
Mortgages
These are loans that homeowners take out to buy a property. The borrower promises to repay the lender (usually a bank or a mortgage company) with interest over a fixed period of time. The property serves as collateral for the loan, meaning that the lender can foreclose on it if the borrower defaults on the payments.
Corporate credit
These are loans that businesses take out to finance their operations or expansion. The borrower promises to repay the lender (usually another business or an investor) with interest and sometimes a share of the profits. Corporate credit may be secured by assets or unsecured, depending on the creditworthiness of the borrower.
Limitations
Promissory notes have some limitations, such as:
Legal enforceability
Depending on the type and complexity of the promissory note, it may be subject to state or federal securities laws and regulations.
This means that the issuer and the payee may have to comply with certain disclosure, registration, and reporting requirements. Failure to do so may result in legal penalties or invalidation of the promissory note.
Risk of default
There is always a risk that the borrower may not be able to repay the loan according to the terms of the promissory note. This may be due to financial difficulties, bankruptcy, fraud, or other reasons. The lender may have to resort to legal action or debt collection procedures to recover their money, which may be costly and time-consuming.
Interest rate fluctuations
The interest rate of a promissory note may be fixed or variable, depending on the agreement between the parties. A fixed interest rate means that the borrower pays the same amount of interest throughout the duration of the loan.
A variable interest rate means that the borrower pays interest based on a benchmark rate that changes over time, such as the prime rate or LIBOR. A variable interest rate may expose the borrower to higher or lower payments depending on market conditions.
Conclusion
A promissory note is a written promise by one party to pay another party a definite sum of money, either on demand or at a specified future date. A promissory note typically contains all the terms involved, such as the principal debt amount, interest rate, maturity date, payment schedule, date and place of issuance, and issuer's signature.
Promissory notes can be used for various purposes, such as personal loans, mortgages, or corporate credit. Promissory notes can also be secured by collateral or unsecured, depending on the risk and preference of the parties. Promissory notes have some advantages and disadvantages, such as legal enforceability, risk of default, and interest rate fluctuations.
References
- Investopedia (2024). Promissory Note: What It Is, Different Types, and Pros and Cons. https://www.investopedia.com/terms/p/promissorynote.asp
- OCBC NISP (2021). Promissory Note Adalah: Pengertian, Contoh, dan Ketentuannya. https://www.ocbc.id/id/article/2021/12/13/promissory-note-adalah
- eForms (n.d.). Free Promissory Note Templates (2) - PDF | Word – eForms. https://eforms.com/promissory-note/
FAQ
A Promissory Note is a financial instrument that contains a written promise by one party (the note’s issuer or maker) to pay another party (the note’s payee) a definite sum of money, either on demand or at a specified future date.
Promissory Notes are often used in business transactions where one party loans money to another. They serve as a formal commitment to repay the loan and can include details about the repayment schedule, interest rate, and penalties for late payment.
Key elements of a Promissory Note include the principal amount, interest rate, maturity date, date and place of issuance, issuer’s signature, and sometimes the payee’s rights in case of default.
Yes, a Promissory Note is a legally binding document. If the borrower fails to repay the loan as agreed, the lender can take legal action to recover the debt.
While both documents are used in lending, a Loan Agreement typically includes more comprehensive terms and conditions, such as clauses about loan security and default. A Promissory Note, on the other hand, is simpler and focuses on the promise to pay a certain amount by a certain date.
