How Do Promissory Notes and Loan Agreements Compare?
Promissory notes and loan agreements are both documents that detail the terms and conditions of a loan.
Loan agreements are formal contracts that provide evidence of a specific amount of money from a lender to a borrower. A loan agreement contains specific details about the loan, how much is to be paid back, interest rates, penalties if the loan is not repaid and other contractual terms that the lender and borrower agree to.
Promissory notes are more informal arrangements in which a borrower promises to repay the lender for a loan. There are fewer legal remedies for the lender if the borrower defaults or can’t repay the loan on time.
Similarities Between Promissory Notes and Loan Agreements
Promissory notes and loan agreements are very different loan arrangements with several differences. But they share three distinct similarities.
- Repayment Terms
- Both promissory notes and loan agreements lay out specific requirements for the borrower to repay the lender a specific amount of money. These typically include the interest on the loan and how long the borrower has to repay it.
- Legal Enforceability
- Loan agreements and promissory notes both hold the borrower legally responsible for paying back the loan. When a borrower signs either a promissory note or a loan agreement, they are legally bound to repay the borrower the amount agreed upon in the document.
- Consequences if the Loan is Not Repaid
- Both loan agreements and promissory notes contain terms and conditions defining what will happen if the borrower does not repay the agreed amount within the term of the loan. Terms include the amount of interest and any penalties for late payments. This can provide the lender evidence in court of exactly what the borrower owes if they fail to make payments on the loan.
Promissory Note and Loan Agreement Similarities
While promissory notes are more informal arrangements, financial institutions still utilize them alongside loan agreements for different kinds of loans.
Differences Between Promissory Notes and Loan Agreements
The differences between promissory notes and loan agreements often make one or the other a better choice for a particular type of loan or set of circumstances.
Differences Between a Promissory Note and Loan Agreement
| Promissory Note | Loan Agreement | |
|---|---|---|
| Security | Typically not secured against the borrower’s assets. | Typically requires security or collateral. |
| Formality | More informal arrangement that can be more easily modified if the parties agree. | Generally lengthy, specifying every detail of the loan and cannot be easily changed by either party. |
| Repayment Terms | May require a lump sum repayment. | Typically allows installment payments over the term of the loan. |
| Remedy for Nonpayment | May not offer a remedy to the lender if the borrower defaults on the loan. | Allows the lender to foreclose on the security or collateral if the borrower defaults. |
| Use | Typically used for owner-financed sales, small loans or loans between friends and families. | Typically used for larger loans like mortgages, auto loans and business loans. |
| Legality | While it creates legally binding requirements for the borrower, it does not legally bind the lender to legal requirements as part of the agreement. | Binds both the borrower and lender to the terms and conditions spelled out in the loan agreement. |
When Is a Promissory Note Appropriate?
A promissory note is most appropriate when the amount of money borrowed is smaller or being lent to a friend, family member or business partner.
Promissory notes tend to work best with someone you have a close relationship with and share mutual trust with.
Companies may use promissory notes for credit with suppliers. The company may issue a promissory note to a supplier if the company has run out of its line of credit. The note typically agrees to pay the supplier when the company collects money it is owed from its debtors.
Private lenders and educational institutions may also make student loans through promissory notes. These notes will contain information about the student’s employment history, repayment period and other personal information along with information about the school.
Promissory notes also work well if the borrower and lender know beforehand that the payback date can be flexible. Again, this typically happens if there is a solid personal or business relationship between the two parties.
When Is a Loan Agreement Appropriate?
Loan agreements are well suited to loans involving large sums of money because a loan agreement also creates a more formal, legally enforceable contract.
Large loans — like a car loan or a mortgage — can be a risky proposition for a lender using only a promissory note if the borrower isn’t able to repay the loan on time. A loan agreement spells out actions the lender can take if the borrower defaults, such as foreclosing on the house or repossessing the car.
While a loan agreement provides the lender more legal remedies to get their money back, a loan agreement also makes it easier for a borrower to take out a loan from a financial institution rather than having to know someone personally to get a loan
Does a Loan Need a Promissory Note?
The term “promissory” is derived from the word “promise.” As such, these notes typically include a promise of repayment.
However, there is no legal requirement for a promissory note to include an actual promise of repayment for some loans. At the same time, nothing prohibits including a promissory note in a loan agreement.
But a promissory note provides evidence of the loan — the amount of the principle, interest and amount to be repaid.
Is a Promissory Note Legally Binding?
Promissory notes are legally binding, whether they are secured by collateral or by simply the promise of the borrower to repay the loan.
If secured by collateral, the lender has the right to take legal possession of the collateral.
If there is no secured collateral, the lender has the right to take the borrower to court or through some other collection process to attempt to prove how much the borrower owes. In these cases, the promissory note serves as evidence.
It is more difficult to recover repayment through a promise alone than if there is collateral involved and described in the promissory note.
Loan agreements tend to afford greater safety for both the lender and borrower. They include more clearly defined terms and conditions of the loan and more clearly defined consequences if the borrower defaults.
