If you’re planning to lend or borrow money, you or the creditor will often present options such as promissory notes or loan agreements to record and bind the agreement legally in writing. However, the exact type of debt instrument you choose will depend heavily on the circumstances of the parties entering into loans.
Showing the payment of the loan amount has been paid and that the borrower commits to repaying the money is an essential step in this process to give both sides confidence and to provide security in case disagreements arise. Whether you’re a lender or borrower when a loan is issued, having a valid debt note is essential.
In this article, we’ll explain the differences between loan agreements and promissory notes in more depth and which works best for certain situations. As you’ll see, whilst both have their uses in enforcing a loan, setting out payment plans and interest rates on the principal sum, one option will suit your needs better than the other depending on your circumstances.
What is a Loan Agreement?
Loan agreements are comprehensive financial contracts that set out the obligations of lenders and borrowers when a sum of money is lent. The most important advantage of a loan agreement is that it is fully binding and legally enforceable for both parties.
Be aware, some banks or financial service companies might refer to their loan agreement as “note”. This can sometimes cause confusion over the type of legal document that is in use. Nevertheless, if you take out a loan from a major lender the repayment of the money will almost always be bound by a loan agreement.
When Should a Loan Agreement Be Used?
Because loan agreements provide a great deal of security for lenders due to their legal formality, they are often used to secure common forms of commercial credit. You will often see loan agreements put to use in the following situations:
A loan agreement is the most legally binding form of lending contract available. Therefore if you want the maximum assurance that both parties will commit to the terms of the accord this is the best choice.
What is a Promissory Note?
This kind of note payable form is used to create a written promise to pay back a sum of money that has been loaned. It details how much has been given to the borrower, how they must repay the credit, and what interest will be added to the principal sum.
In many ways, a promissory note works as a type of IOU document, although it is more complex in practice. However, it is also much more informal than a loan agreement and does not legally bind the lender in the same way, although the borrower is still bound by the note.
When Should You Use a Promissory Note?
Overall, promissory notes are best used when handling smaller, personal loans. This might be something you use when lending money to family members and close friends.
A promissory note is a simpler and less intimidating loaning document. It works much better at providing guarantees that lenders need without the heavy legal nature of a loan agreement at the expense of a little more risk.
In all situations, promissory notes work best when there is a good level of trust between the lender and the borrower. This allows the parties to forego some of the protections that would be offered in the case of a loan agreement.
What Are the Main Differences Between Loan Agreements and Promissory Notes?
Promissory notes and loan agreements have a lot in common. This includes elements such as their adherence to usuary laws, creating a record of the money borrowed, providing repayment schedule details, or the consequences of late payment. However, they also have some quite significant differences between them.
Firstly, a loan agreement is a much more formal and complex document. It offers a good amount of specific legal protections and can have serious consequences if it is violated. Therefore, creating and signing a contract like this is a more serious undertaking.
A promissory note is less robust and is simpler in nature and works better when smaller amounts are being lent short-term. However, it still protects the lender from potential defaults and the risk of lending an unsecured or undocumented amount of money. It also provides the correct level of detail to ensure both parties know what kind of agreement they are entering into.
Whichever kind of debt instrument you use, it has to suit the interests of both parties and offer the correct assurances and protections that will allow trust to exist that a loan will be repaid. This will permit the lender and the borrower to feel comfortable lending and repaying the principal sum and offer guarantees of commitment to the terms agreed.