When loaning money to family or friends, it’s tempting to accept an informal “IOU” – but if you’re lending a large amount, it’s a good idea to write up a formal promissory note.
A formal agreement not only assures that your loan will be repaid but it’s also in the best interest of the borrower.
Why? Because it’s easier to prove a written agreement in court.
You never really know if someone will honor a verbal agreement. A promissory note can at least give you some recourse if a personal loan falls through.
What is a promissory note?
Lending money to a friend or family member isn’t always easy, and we tend to be more lenient with our own kin, even at our own expense.
Taking someone at their word wouldn’t be acceptable in business, but a handshake is usually the way to go when you exchange money between two trusted parties.
Unfortunately, memories fade, disagreements arise, and personal relationships and money never mix well.
You can protect yourself with a promissory note, a written promise to pay money to someone. Although it’s technically a formal document, it isn’t a contract.
A contract details all the terms of a legal agreement, whereas a promissory note enforces a borrower’s promise.
What terms are covered in a promissory note?
A promissory note is a small, self-contained document that won’t need a dedicated terms and conditions section but is instead a simple agreement.
A promissory note covers the following:
- The date when the lender needs to be paid.
- How the business or person needs to be paid.
- How much the company or person needs to be paid.
The usual standard of mutuality, consideration, meeting of the minds, lack of ambiguity, and competency used to execute any other contract is still valid here.
Usually, a promissory note is backed up by another contract. You’ve probably had to sign a promissory note when you were taking out a loan or hiring out for a big project.
For example, if you were hired to build a house, you could use this construction contract template to outline your company’s terms.
Then, draft a second promissory note agreement and attach that to the contract. Both need to be signed to be legally binding.
Is it legally binding?
Yes, promissory notes are legally binding promises as long as they’re signed.
If someone doesn’t repay a loan detailed in the promissory note, they could lose assets tied to the loan. When you sign a promissory note, you agree to pay the terms or face legal consequences.
If you’re drafting one for a friend or family member, explain that this promise isn’t the same as a verbal IOU. Otherwise, they may be confused about the agreement terms, which could void the contract and/or the promissory note.
Who should use a promissory note?
Anytime you’re lending out money, you should use a promissory note. Still, that doesn’t mean there aren’t differences between promissory notes from different lenders.
What kinds of lenders use promissory notes?
Most lenders will use promissory notes. Here are some common types:
- Real estate notes: Asks the borrower to pay for the total cost of the property.
- College loan note: Asks the student to repay their educational expenses.
- Investment note: Asks a business to pay back an investment amount if the company doesn’t raise enough capital for an investor to see a return on investment.
- Car note: Asks the borrower to make regular payments on a car loan.
The above examples are also known as “commercial notes” because you’re borrowing money from a commercial lender. Personal notes are only made for friends and family.
Do notes differ when used by a commercial vs. a personal loan?
A corporation or commercial promissory notes are more formal than personal notes.
Commercial notes often give specific conditions that the borrower must meet, like credit score, financial documents, and income, to receive one.
They almost always require the borrowers to repay the loan with interest. Commercial notes back up their loans with collateral.
With a personal loan, you have some flexibility. Since they’re typically made to set an agreement between friends and family, some personal promissory notes won’t include details regarding the purpose of the loan. But they should, even if you trust the borrower.
Can they be used for any dollar amount, or is there a minimum?
Promissory notes and loans don’t have a minimum dollar amount. They can be used for any amount, but you may feel silly drafting one for $10.
Still, $10 is a lot of money for many people, and losing it forever could put you in severe financial stress. Don’t let the amount deter you from drafting a legally binding loan.
Some institutions will limit the amount they lend out, even if you have great credit. For example, Banks that write promissory notes can’t exceed 15% of their capital to a single borrower.
How to write a promissory note
Writing a promissory note doesn’t have to be difficult. In fact, you can use this promissory note template from PandaDoc instead of creating your own. Just fill in the blanks!
At its most basic, a promissory note should include the following:
- Name of lender and borrower
- Loan amount
- Is the loan secured or unsecured?
If it’s secured with collateral:
- What is the collateral?
- When can the lender take possession of collateral?
An unsecured promissory note won’t be secured by assets. If the borrower stops making payments, they must file in small claims court or go through other legal processes to enforce the note.
For this reason, a secured note is better because you have the right to seize property:
- Payment amount and frequency, due date
- Is there a co-signer? Who is the co-signer?
Signing and storing a promissory note
Ask a lawyer to check over your loan to ensure you’re not unintentionally violating any laws.
An attorney can also help fix up your language and delete white space, which the borrower could use to add other terms to the loan.
Still, hiring a lawyer isn’t necessary. It can be expensive to take a contract to an attorney.
Once you draft the note, everyone needs to sign it. To make this process easy while also ensuring your contracts maintain legal compliance standards, use a top eSignature software that offers a free trial or permanent free plan, like PandaDoc.
You can create, send, sign, and store all of your documents using the PandaDoc platform, which beats using a locked filing cabinet!
How to make changes to a promissory note
Writing up a second document is simpler than changing a current note. If you keep the previous note, you’ll need to get permission from the borrower and/or co-signer to make changes.
The new document should state that anything said or written outside the current agreement won’t be honored. For example, this business contract template states in the “Entire Agreement” section that this document is the entire agreement and can’t be modified except in writing.
Are you charging interest?
Charging a friend or family member interest on a personal loan can make you or the borrower feel that you’re ungenerous, but there are several reasons why you’d want to add interest to your terms.
Unless you’re doling out a loan that’s less than $500, you should always charge interest.
Pros and cons of charging interest on a personal loan
Pro: Incentive for payment
Interest rates are an incentive for payment. Without applying an interest rate, your friends or family members may take their time paying you back.
What’s more, it may keep others from treating you like an endless source of cash supply, which helps protect your investments.
Con: Familial reputation
The biggest con of adding interest to a personal loan is how your friends or family members view you.
Most people consider the act of charging interest as greedy.
Why you need to charge interest anyway
Many of us are not aware of how the IRS treats interest on loans. If the IRS learns that you’ve given out an interest-free loan, they can impose interest on the loan anyway if the loan amount exceeds the gift-tax exclusion ($15,000 or more).
Interest will be seen as taxable income by the IRS, which means you’re paying extra to lend someone money. That isn’t fair to you or the person borrowing from you, as you may realize your mistake and ask for interest later.
What’s more, the lender could have earned interest on the money they lent out.
For example, if you gave away $5,000 instead of putting it in a certificate of deposit, you pay the cost of loaning the money.
How to explain to your family that interest is important
Explain to your family members why you have to charge interest and explain that it isn’t because you don’t trust them. You need to ensure that you’re doing your due diligence for the IRS and saving your own investments.
You can state that paying you off faster will lead to lower interest rates.
Or, you can offer another incentive that ensures prompt payments, like cutting them off financially if they continuously loan money from you. Explain that your interest rates are lower or the same as a bank loan.
Remember: A person who cares about your interest won’t intentionally avoid paying you. There are several reasons why someone can’t pay you back, but if the borrower is spending a lot of money while explaining to you that they’re broke, it’s important to recognize this behavior as disrespectful.
If they’re offended by the concept of interest from a family member, especially if you haven’t loaned money to them in the past, that’s a good sign that you should be charging interest. They may be more likely to default on payments if you don’t offer an incentive.
You don’t have to loan out money to everyone. If something is off, trust your gut.
State laws regarding interest
Usury laws govern the legal rate of interest for all states.
The legal rate of interest is the highest rate of interest that can be legally charged for any type of debt. All lenders have to adhere to these laws. Yes, even personal loans backed by promissory notes can’t charge exorbitantly high-interest rates.
But, there’s one exception. Credit card companies can charge interest rates where the company was incorporated. South Dakota and Delaware have the highest interest-rate ceiling in America, so it’s common for banks to incorporate there.
Any interest rate that exceeds the legal rate of interest is classified as “usury,” which comes with some harsh penalties. Usury in most states will come as a fine or forfeiture of principal and/or interest. Each state is responsible for setting its usury rates.
For example, New York will set their rate quarterly. Their rate usually caps at 15% for most loans or credit cards. At 16%, a person will commit civil usury.
Criminal usury includes interest rates that exceed 25%. On average, states will set a 10% difference between civil and criminal usury.
Some states will use different caps for different financial products.
How to calculate interest on repayment plans
There are four main repayment plans, some of which can be combined. For example, you could ask for a lump-sum payment after signing the promissory note then initiate the installment repayment plan.
Lenders will calculate interest in the following ways:
- Lump-sum: A lump-sum payment is a total sum the borrower pays back to the lender. This is common for smaller loans but may be added at the beginning of large loans.
- Due on demand: A due on demand or open-ended loan is due when the lender says so. These are common with informal notes or notes that don’t have payment terms.
- Installment: An installment plan lets the borrower pay the lender back over time.
- Balloon: Balloon payment plans include equal installments for a predetermined amount of time that either consists of the principal and interest or the interest only. The borrower will often make a final lump sum payment at the end of the loan date.
Interest can be applied either on the total amount of the debt or per installment.
You can also add a separate interest rate to your contract that might activate if the borrower doesn’t pay for a certain amount of time.
For example, you could change the rate from 5% to 7% after missing two installments.
You can use an online personal loan calculator to see how much the borrower would pay per month. Just type in the loan amount, terms, and interest rate per annum.
What happens when the loan is not paid?
You can protect yourself from loan default by applying past due notices or a partial payment option. If your personal loan is way past due, you can sell their debt to debt collectors.
Issue your loan repayment strategy in the following order:
- Past due notice: Explains that the loan is past due and requires payment. Your past-due notice may or may not include interest or a lump sum extra payment.
- Offer a partial payment option: If your payment schedule doesn’t work for them, try another one. Or ask for partial payment by a specific date.
- Debt collectors: Issue a final notice that if their debt isn’t paid by a certain date, you’ll sue them for damages or send the debt off to a collections department.
Use your discretion when dealing out past-due notices. You probably know who you can take on their word. If they’ve made regular payments and they’re late, even without notice, handing them a past due notice may damage your relationship.
If there’s a pattern of lateness, you could try a 3-strikes system, where you can ask your friend or family member for the payment 3-times within a month before you issue a notice.
As long as you have the promissory note to back up your claims in court, you’ll be able to protect your assets.
Protect yourself with a promissory note from PandaDoc
Writing a promissory note is a great idea. Whether you’re drafting a business or personal loan, a note can protect you and your investments if the borrower doesn’t commit to paying you back.
However, a promissory note must be written with the law in mind. Feel free to use our free promissory note template to produce a binding agreement, but if you plan to draft, sign, send, and save loans full-time, use PandaDoc.
Sign up for our 14-day free trial to learn more about our platform. PandaDoc will help you move documents as your business grows into an enterprise.