Promissory notes are legal and financial instruments written between three parties: the borrower, the lender, and the maker or issuer. The documents contain details of the debt, including loan circumstances, maturity date, issuance terms, amount payable, interest rate, and more. It is like a written promise to assure the lender that they will receive the money from the borrower as specified in the agreement. A borrower must sign a promissory note even when taking a small Personal Loan.
In the following sections, we will discuss what is a promissory note, how it works, its types, features, etc.
What is a Promissory Note?
A promissory note is a written promise a maker makes for companies and individuals. The note attests to the lender’s validity and promises the borrower’s creditworthiness for a loan. In India, it is a legal instrument that binds the parties legally under Section 4 of the Negotiable Instruments Act of 1881.
According to the promissory note definition, it can be a secured or unsecured note. A secured note functions like a bank loan that requires collateral for security. Conversely, an unsecured note requires a healthy credit score rather than a security. It can also be a security, thus traded on the Indian money market by traders and banks. Lying alongside a bill of exchange, it contains a promise and the path to fulfil it.
How Do Promissory Notes Work?
Promissory notes work by serving as financial instruments in lending and borrowing transactions. They are written promises a borrower makes to the lender to repay the borrowed amount within a predetermined time frame. It outlines key terms of the transaction, including the principal amount, interest rate, and repayment schedule.
Once both parties sign the document, it becomes a legally binding document that both parties must abide by. Its primary function is to define the promise to pay by a future date or on demand, as both parties agree mutually.
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What's Included in a Promissory Note?
A promissory note format includes all the details about a loan and its repayment terms. The details include the following:
- Name and address of the borrower and the lender
- Borrowed amount
- Maturity date
- Repayment schedule
- Interest rate
- Interest rate calculation method
- Prepayments clause
- Interest chargeable on an overdue payment
- Default options
- Amendments, waivers, and governing laws
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Features of Promissory Note
Look at the following features of a promissory note:
- Agreement in Written Form: A promissory note is in written form, with no acceptance of an oral promise.
- Defines the Payable Amount: It defines a promise to pay the due amount at a specific time or when demanded. The amount mentioned in the note remains fixed without any scope for modification.
- Signatures: The document is duly signed and stamped by the drawer.
- Absolute Promise: The promise to make a certain payment amount remains absolute under all circumstances. It does not accept a conditional guarantee.
- Legal Composition: Every payment should be made in the country’s legal currency.
- Detailed Information: The note contains all the required information, including the parties’ names, issue date, date of maturity, repayment terms, principal amount, rate of interest, etc.
Types of Promissory Notes
These are the types of promissory notes you may come across:
1. Secured Promissory Note
A secured note requires the security of an asset as collateral against the loan. It typically describes the collateral that secures the amount borrowed. For instance, when borrowing a loan, the borrower can pledge their house as collateral. If the borrower fails to repay the loan, the lender can possess the property and resell it to recover the loss.
2. Unsecured Promissory Note
As its name suggests, an unsecured note is collateral-free; you can sign without security. Lending companies determine an applicant’s loan eligibility and other terms and conditions according to their credit rating, debt-to-income (DTI) ratio, and other determining factors.
3. Demand Promissory Note
A demand promissory note specifies ‘’on demand’’ repayment, which means the borrower must repay the loan whenever the lender demands. It is not due by a predetermined date and has no repayment schedule. Sometimes, loan providers offer such loan plans to their existing customers with favourable credit histories.
4. Term Promissory Note
It defines a loan term during which the borrower must repay the loan at a specific interest rate. It contains a particular future date for repayment, after which the borrower becomes liable for legal action or collateral loss.
5. Installment Promissory Note
It is a common note to determine how the borrower will make regular payments according to the repayment schedule. It details the EMI amount, interest rate, and repayment plan.
6. Fixed-Rate Promissory Note
It applies to a loan with a fixed interest rate that remains the same throughout the tenure. The lender determines the interest rate at the time of loan approval. The borrower pays a fixed amount of EMI to repay the loan by the end of the term.
7. Variable-Rate Promissory Note
It applies to a loan with a variable interest rate that changes according to market fluctuations or other factors. It specifies the factors affecting the interest rate and the changes it makes to the repayment schedule.
8. Commercial Paper
This note deals with commercial lenders like banks. It is a short-term, collateral-free debt instrument corporations typically issue to finance short-term liabilities.
9. Real Estate Promissory Note
It applies to a real estate loan, specifying that if the borrower defaults, the lender has the legal right over the property. It is a key piece of a mortgage agreement and home loan application, ensuring a borrower agrees to borrow from the lender and repay them according to the agreed repayment schedule.
10. Corporate Promissory Note
A corporate promissory note is used when a borrower raises funds for a business. It is typically used when a company borrows a loan from a lender and agrees upon a predetermined repayment plan.
Parties of Promissory Note
When you look at a promissory note example, you will notice three primary parties involved. They include the following:
- Drawer: The person who issues the note to receive a payment.
- Drawee: The person who needs to pay the amount to the drawer.
- Payee: The person who receives the payment.
Conclusion
A promissory note is an important financial document that gives certainty and validity to a lending transaction. The agreement can be between two parties, whether a borrower and a lender or two financial institutions. It is written evidence of the borrowed amount and outlines essential details about the parties involved. For instance, when you borrow a Hero FinCorp Personal Loans for students, read this document carefully to protect your rights and clearly define the loan terms and conditions.
Frequently Asked Questions
1. How does a promissory note differ from a loan agreement?
The primary difference is that a promissory note does not bind the lender in any way.
2. What are the key elements of a promissory note?
Key elements of a note are the principal amount, maturity date, interest rate, repayment schedule, date and place of issuance, issuer's signature, etc.
3. Is a promissory note legally binding?
Yes, a promissory note is a legally binding document.
4. What information should be included in a promissory note?
Promissory notes include information like the principal amount, maturity date, interest rate, repayment schedule, date and place of issuance, etc.
5. Can the terms of a promissory note be negotiated?
Under Section 58, a promissory note is negotiable by delivery.
