What Is Promissory Note?

A promissory note is an agreement between two parties in which one party promises to pay the other a specified amount of money, usually in exchange for a loan. This is a legal document that creates a financial obligation to be fulfilled at a certain date. 

Understanding the promissory note meaning is an important part of loan agreements as it allows parties to conduct transactions with trust and transparency. It acts as a contract form and contains details of the loan including the loan amount, interest rate, maturity date, and note terms, among others. This article will cover what is a promissory note, how they work, and whether they are beneficial.

How Does a Promissory Note Work?

Issued under Section 4 of the Negotiable Instruments Act of 1881, promissory notes create a debt promise where the borrower agrees to repay the amount loaned to them by the lender within a specified period. This loan contract acknowledges the debt and can be used by financial and non-financial lenders alike. They allow more flexibility over loans from traditional financial institutions, allowing almost anyone to become a lender, and are legally binding once both parties have signed.

What Are the Types of Promissory Notes?

There are many types of promissory notes. Some of the common ones are:

• Secured: These are backed by collateral, such as a house or a car, and offer the lender more security.
• Unsecured: This note agreement is not backed by collateral.
• Demand promissory note: This requires the borrower to pay the lender back at their request.
• Instalment promissory note: The borrower must make payments in fixed instalments.
• Joint promissory note: This includes multiple borrowers sharing the liability.
• Convertible promissory note: Often used in business loans, this type of note can be converted to equity (such as shares in a company) under certain circumstances.

What Is Included in a Promissory Note?

Let us take a look at the important components you can expect to find in a typical promissory note template, detailing the loan and the repayment terms:

• Parties involved: These are the names of the borrower and the lender.
• Principal amount: It will specify the loan amount being borrowed.
• Interest rate: This is the annual interest rate applicable.
• Repayment terms: This will detail how and when the loan will be repaid.
• Maturity date: This is a set date by which the loan must be fully repaid.
• Instalments: If the payments are to be made in instalments, the amount and number of payments will be included.
• Late fees and penalties: These are the charges a borrower will have to pay if they do not pay on time.
• Default: This is what counts as default and the consequences of it.
• Signatures: Both parties need to sign for the note to be valid.

These details are important in ensuring transparency, validity, and clarity.

Which Parties Are Involved in a Promissory Note?

There are two parties involved in a promissory note. These are the maker or the drawer and the payee. The maker promises to repay the borrowed amount to the payee. The note may also include cosigners who agree to repay the loan if the maker defaults. These parties are essential to ensuring the note is legally binding and clearly outlines the responsibilities of all parties involved.

What Are the Pros and Cons of a Promissory Note?

A promissory note is a type of loan contract, and so, it has both advantages and disadvantages. One of the pros is that it allows borrowers to take loans from sources other than traditional financial institutions. This gives them a wider range of lending options and can help when they are unable to secure a loan the traditional way. It is detailed, can provide clarity about the loan terms, and has legal enforceability. 

However, it can be risky for the lender if they lack the resources that a traditional lender would have. Due to this, enforcing repayment and checking the creditworthiness of the borrower can be difficult, increasing the risk for the lender. This can mean higher interest rates and stricter conditions. Moreover, if the borrower defaults, individual lenders might find it more difficult to collect the owed amount compared to larger financial institutions with established collection processes.

Conclusion

A promissory note creates an obligation on the borrower to repay the amount lent to them. It has both advantages and disadvantages as it allows borrowers to take loans from sources other than traditional institutions. However, it can be risky for the lender and lead to higher rates and more stringent conditions for the borrower. 

SMFG India Credit ensures a smooth and transparent borrowing process, with approved funds getting disbursed within 30 minutes* of personal loan approval. Contact us or visit your nearest branch to know more.