June 18th, 2021
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June 18th, 2021
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5 - 2 votes
Imagine the following scenario: a friend or family member has asked you for money to buy a car, make their rent payment, or help pay an overdue bill. You're okay with providing the loan, but you aren't sure if you need a formal document. You decide to give them the money back without having them sign anything.
Later, you regret it! Your friend or family member hasn't made any of the payments you previously discussed, and you are left not knowing what to do in order to get the money you are owed.
Unfortunately, this situation is all-too-common between people that make loans to friends or family members, also called "friendly loans." It's normal to trust the friend or family member that you are providing a loan to, but it's just as normal to find yourself caught in a situation where you don't know how to recover the money you let them borrow.
In this guide, we'll discuss the details of promissory notes, as well as give you some information about using them for friendly loans. Please be advised that nothing in this guide is meant to constitute legal advice, and it should instead be taken as informational only.
First thing's first, what exactly is a promissory note? Although it is very official-sounding, a promissory note is simply a document from a borrower to a lender that basically says the borrower will promise (hence the name) to pay back a certain amount of money. You can think of it like an "IOU," except that it usually contains more comprehensive details about repayment than a simple IOU.
A promissory note is very similar to a Loan Agreement, except in that case, the promissory note is usually much simpler than the Loan Agreement. A Loan Agreement is a much more formal contract evidencing the loan of a certain amount of money from a lender to a borrower. There are several specific types of loan agreements, depending on what the loan is being given for.
A well-drafted promissory note will generally contain the following specific provisions:
The most obvious clause for the promissory note to contain is the amount of money to be paid back. This sounds like a no-brainer, but much of the time, disputes about friendly loans happen because the parties claim different amounts are owed. Having a written note drafted with the specific amount of money to be paid back is critical in ensuring the parties are on the same page.
This clause in the promissory note will contain the whole amount of money to be paid back - in other words, if interest is included, it would be included here.
There wouldn't be any point in having a promissory note unless there was a date by which all the money needs to be paid back. This is the second most important term in the note!
If the due date comes and goes and the borrower hasn't paid up, the promissory note will contain a provision about past due fees that may be charged. Usually, the past due fee will be a percentage of the total amount owed.
Default is when a party to a contract fails to meet its obligations. In the case of a promissory note, there is only one signatory (more on that below): the borrower. Therefore, the promissory note will detail what specific events constitute the borrower defaulting on the loan.
Usually, default involves any action taken to indicate the borrower is insolvent, or doesn't have funds remaining to satisfy the loan.
If the borrower does default, what rights do you have, as the lender? A good promissory note will make this clear.
Usually, the promissory note allows the lender to try to collect the full amount right away in case of default. Additionally, if the lender expends any fees in trying to get the borrower to pay the loan back, the lender can add those fees to the amount due.
If there is collateral attached to the loan, the promissory note should contain this information. Collateral is a physical item or items that are being used to secure the loan. The most common collateral-secured loan is a mortgage.
In this case, the collateral could be the item that the loan was used for - in other words, perhaps the car that the borrower purchased with the loan received. It could also be any other item not related to the loan funds, like a prize guitar worth $15,000 that would become the property of the lender in case the borrower didn't pay the loan back.
One important thing to consider about promissory notes is that they don't "bind" the lender. "Bind" in this case means legally tie a party to a contractual obligation. The way to legally tie someone to a contract is to get them to sign it.
A promissory note generally only requires, and has space for, the signature of the borrower. So the borrower will be signing, agreeing to all of the terms, but the lender will not.
This doesn't mean the lender won't get the money or that the borrower isn't obligated to pay it back, it just means the lender is not contractually obligating themselves to anything.
In a more complex document, like a completed Loan Agreement, both the borrower and the lender will sign. This is because Loan Agreements usually have much more specific and comprehensive terms.
As noted above, the promissory note will contain the amount of money owed and the date by which it needs to be paid back. Usually, however, it won't contain payment interval information, like requirements for a monthly payment. This is because the promissory note is meant to be as simple as possible while ensuring it covers all the information required for the lender to get their money back.
So, let's get back to our original question: should you use a promissory note for a friendly loan? In almost all cases, the answer will be a strong yes!
There is no downside to having a well-drafted, comprehensive agreement governing your financial security in making a loan to a friend or family member. In fact, there is only a lot of upside! First off, if you do need to pursue legal claims against that person, you'll have a signed document to back you up. Second, it may even help preserve the relationship with your friend or family member! When terms aren't clear, there is a lot to squabble about, but when there is a short, to-the-point document, everyone can be on the same page.
As you can see, promissory notes are important documents that help structure a loan repayment between you and a friend or family member. They are usually fairly simple to draft, and won't take up too much of your time. They will, however, help you avoid a lot of headaches.
As always, if you have specific questions, or are considering a document for a more complex transaction, like Loan Agreement, it's a good idea to check in with an attorney licensed in your state who specializes in this area. They would be in the best position to advise you on your individual needs.
About the Author: Anjali Nowakowski is a Legal Templates Programmer at Wonder.Legal and is based in the U.S.A.