The Difference Between Promissory Notes & Loan Agreements
A promissory note and a loan agreement both outline arrangements for repaying borrowed money, however their legal connotations differ.
The lending process can be a daunting experience, particularly if you are not familiar with the documents you must sign. Whether you are a borrower or a lender, it is important to consider what type of document you will use to set out the terms of your loan. Typically, lenders may use their own agreement as a basis for negotiating with borrowers, which may take the form of two documents. First, a promissory note. Second, a loan agreement. Generally, there are differences you should be aware of so you can distinguish between the two.
When drafting a promissory note or loan agreement, you must ensure the legal instrument is correct, accurate and reflects the wishes of both parties.
What Is A Promissory Note?
A promissory note is a negotiable instrument that you can issue. This note contains a promise to pay a sum of money. It is also sometimes known as an IOU, Payment on Demand, or Payment on Arrival. It is a formal contract between parties that contains a promise to pay a certain amount of money on demand at a specified time, or over a period of time in future. A promissory note usually covers smaller loans.
Once two people enter into a promissory note, the individual who promises to pay is called the payer (borrower). The person who is owed payment is called the payee (lender). Both the payer and payee have legal obligations when a promissory note is signed and dated.
When can I use a promissory note?
You can issue a promissory note if you would like to record a sum owed to you or a sum payable to you. You can use a promissory note in a range of situations that involve a small sum of money. A common example of this is if a close friend or family member asks to borrow money. A promissory note is a good idea if you do not want to draft or sign a loan agreement, but still want evidence of the sum owed to you.
What is a loan agreement?
A loan agreement serves a similar purpose as a promissory note. Like a promissory note it is a contractual agreement between a lender who agrees to loan money to a borrower. However, a loan agreement is much more detailed than a promissory note. There are two types of loan agreements. First, unsecured loan agreements that have no security against the loan if the borrower defaults. Second, secured loan agreements that enables the lender to recover money from the borrower’s asset/s to repay the debt.
When can I use a loan agreement?
You can use a loan agreement in many situations that involve a substantial amount of money. These include lending to a friend to purchase a car or lending to a child for a house deposit. Additionally, a loan agreement will allow you to charge a borrower late fees or if they default on the loan.
A promissory note is a simple document that is not as complex as a loan agreement, and may be shorter and less detailed. It is a useful way of recording a promise to pay back money. Also, it is a good way to establish a clear written record or paper trail of a loan between individuals or entities (such as banks). It minimises confusion and misunderstanding when loaning or borrowing money.
However, if the promissory note contains complex clauses, be aware that it may be deemed to be complex financial instrument. This means it will be regulated by the Corporations Act 2001 (Cth). If this is the case, it is extremely important to seek the assistance of a contract lawyer.
Unlike a promissory note, a loan agreement imposes obligations on both parties, which is why both the borrower and lender must sign the agreement. A loan agreement should state what purpose the loan is used for, and whether the borrower must provide compensation if the lender suffers loss. Overall, it is a complex document. For more information about what considerations you must make, check out our previous guide How To Create A Loan Agreement.
The type of legal instrument you choose will depend on the circumstances of the loan and the relationship you have with the borrower/lender. Either way, if you decide on using a promissory note or loan agreement, you need to make sure that you draft it correctly.
Fiona is a Paralegal working in our content team which aims to provide free legal guides to facilitate public access to legal resources. With an interest in information, media, consumer and employment law, her primary focus is on how technology will affect the future of the legal industry.