Many people are taking advantage of the uncertainty caused by the pandemic to get their dream business off the ground. While banks may be eager to lend money, some new business owners are looking to friends and family to help them fund their new ventures.
Money can drive a wedge between loved ones, even when you think it could never be an issue in your situation. If you are considering lending money to a friend or family member, you may want to take steps to protect your financial interests. One way you can do that is to document the loan terms through a promissory note.
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What are promissory notes used for?
A promissory note is sometimes referred to as a “note payable.” It is a financial instrument that sets out loan terms between two parties. It will include all conditions of the loan, and each party will sign the promissory note to acknowledge that they understand and agree to the terms.
Common elements of a promissory note are:
- The loan amount
- Repayment terms (such as a lump sum or smaller payments over time)
- Repayment deadlines
- Interest rate
Promissory notes are also sometimes informally called “IOUs” or simply a “note.”
How do I make a promissory note to loan money to a friend or family member?
Promissory notes can be fairly straightforward. They can lay out that you are loaning money and when you expect that money to be repaid. You can also get creative with the promissory note to make a repayment structure that works for your situation.
Promissory Notes with Payment Plans
Some promissory notes will set out repayment amounts by a certain date. Others will establish a repayment structure featuring periodic payments or other terms. Below are just a few examples.
- Installment Payments. A promissory note with installment payments will set out a specific amount of money that must be paid periodically, such as weekly, monthly, quarterly, or annually. You and your friend or family member can work out any installment plan you like. Those installments generally continue until the entire loan is paid in full.
- Payable on Demand. A promissory note that is due on demand does not have a specific due date, but you (as the lender) have the right to demand repayment whenever you like. In many situations, the lender will make the demand, and the borrower will make arrangements to repay the debt within a certain amount of time. This type of promissory note is often used between friends and family because it allows a lot of flexibility while also providing evidence that that loan was made.
- Balloon Payments. A balloon payment is a larger payment that often follows a series of installment payments. For example, imagine you loan a friend money for a short time while they refinance their business. You think they will refinance in the next 12 months, so you set up a loan for $10,000, with monthly payments of $420 and a balloon payment of about $5,000 at the end. The refinance should pay you off so your friend can afford to make the larger payment at the end.
Secured Promissory Notes
A promissory note is “secured” when it is tied to a specific property. Car loans and home loans are the most common type of consumer secured promissory notes. In a business, secured loans can be tied to vehicles, equipment, real property, and more.
For example, imagine your friend wants to purchase a new oven for her commercial bakery. You decide to loan her money to buy the oven. If you would like the debt to be tied to the oven, you could create a secured promissory note. That way, if she defaults on the loan, you can take the oven and sell it to get all or part of your money back.
Keep in mind that you may need to meet specific recording requirements for this type of transaction. You might need to file a notice with the secretary of state, so other potential lenders know that you have an interest in the oven. Talk to a lawyer about the requirements in your area to fully protect your rights in that situation.
All Rocket Lawyer Promissory Notes are digital signature-ready using Rocket Sign. If you are using your own document, you can upload it to your Rocket Lawyer account and add text, date, and signature fields for digital signing as well.
Does a promissory note include interest?
Most formal promissory notes will include interest, but it is not a requirement for a legally valid promissory note. If you do not want to charge your friend or family member interest, then make the loan interest-free or use 0% as your interest rate.
Leaving out the term entirely can mean that interest is automatically charged in some situations, so it is a good idea to still include a term that addresses interest in your promissory note.
What makes a promissory note invalid?
Promissory notes are flexible, but you have to include a few vital elements to ensure it is legally valid.
- Name of the parties involved
- Terms of the agreement
- Signatures by both parties
If you have questions about making a promissory note, ask a lawyer to get answers tailored to your specific situation.
This article contains general legal information and does not contain legal advice. Rocket Lawyer is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.