Promissory Notes (Are Not Love Letters)

December 11, 2012 0 Comments

I’m in the process of revising Business and Legal Forms for Graphic Designers. Included in the new material is a discussion of promissory notes and a form for a promissory note. Since this information is equally useful to everyone who lends or borrows, I decided to include it as a post.

A promissory note is documentation of a loan that has been made either to an individual or a company. The note includes the amount of the loan, the rate of interest, the time for payments of principal, and the term during which the loan will be outstanding. At the end of the term, the loan must be repaid in full.

One of the key issues is how often interest will be calculated. If the loan is for a year, interest is calculated daily, and payments of interest are made on a monthly basis, then the borrower will end up having the loan amount increase with each daily addition of interest and then paying the monthly interest payment on the principal plus the added interest. This “compound interest” has been called the Eighth Wonder of the World because of the way it makes money increase. Any borrower has to take care in reviewing how often interest is charged in relation to how often interest is paid to the lender.

The way in which the principal of the note is repaid is also important. Will there be monthly installments? If so, will the loan be repaid in full by the expiration of its term? Or will there be a partial or total balloon (i.e., a part of the loan that must be paid on the end date of the term)?

In the event of the borrower’s default in the payment of either interest or principal payments when due, will the lender have the right to accelerate all of the borrower’s obligations and demand immediate repayment? The note may have a specific provision dealing with this or say something like, “Time is of the essence with respect to payments due hereunder.” The borrower will ideally have the right to prepay the loan so that the interest payments can be avoided if, in fact, it becomes possible to prepay the principal amount.

States have laws forbidding interest rates that are too high. Such rates are considered “usury”. While usury rates vary widely from state to state, it would be wise to determine the usury limit of the state whose laws will govern the promissory note. Also, Form 36 has a saving provision that would change payment of usurious interest into payments of principal in an effort to save the validity of the promissory note.

The promissory note may also place an obligation on the borrower to pay the lender’s legal fees and other expenses in the event litigation is necessary to enforce the note and collect monies due.

Also, the lender may insist that the promissory note be guaranteed. If an individual is signing the note, the guarantor could be someone with more substantial assets who would agree to honor the terms of the note if the borrower failed to do so. If a corporation is signing the note, the guarantor might be a shareholder of the corporation who in the absence of such a guaranty would not be liable because of the limited liability accorded to corporate shareholders.

As the caption for this graphic says, “No debt, no trouble.” But that would be in an ideal world!

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