Types of Loan Agreements
Loan agreements are the legally binding contracts that lay out the terms of the loan between a borrower and lender or investor. These agreements are typically initiated at the request of lenders, banks or lenders to reduce the risk associated with underwriting and approval processes. They also serve to establish the foundation for the lending process in the event of a default.
The purpose of a loan agreement is to define the relationship between two or more parties and to streamline the process of borrowing and lending money by clearly stating all details of repayment. In other words, it is a formal, legally enforceable way of agreeing to lend and, in turn, use money .
The most common details a typical loan agreement includes are:
Since the primary goal of a loan agreement is establishing a formal relationship between the parties, they are generally used by larger organizations as well as banks, financial institutions and investors. They are the mainstay of the world of commercial lending and are frequently used by investment funds, private equity firms, hedge funds, banks, venture capital firms and other institutional investors. Many companies, including Apple and Facebook, use loan agreements to mitigate risks involved with credit.
What is a Promissory Note?
A promissory note is a legal instrument wherein a party (the "maker", "borrower" or "debtor") promises in writing to pay a certain sum of money to another (the "payee" or "lender") at a specified time or on demand of the payee. A promissory note is a negotiable instrument; upon making proper indorsements, an original payee can transfer his or her rights under a promissory note to another party.
The primary purpose of a promissory note is to provide a written statement of the debt between the maker(s) and the payee. In the event a dispute later arises between the parties regarding the debt or its terms, the promissory note serves as evidence of the debt and its terms.
Though a promissory note may be structured in any manner agreed by the parties, it typically conveys the following information:
There are countless instances where a promissory note is commonly used. Some examples include:
A promissory note is a simpler document than a loan agreement and may be preferred by the parties if less complexity is involved.
Key Differences Between Loan Agreements and Promissory Notes
The first difference between a loan agreement and promissory note is that a promissory note is a unilateral document while a loan agreement is a bilateral document. A promissory note is one-sided, showing only the promise made by one side to pay to the other a granted amount of money. A loan agreement is bilateral as it shows the promises of both the lender receiving interest and the borrower paying out.
Another difference between a loan agreement and promissory note is that a promissory note is typically the less complicated of the two choices. A promissory note’s simplicity is because the document shows only the promise by the borrower to repay money to the lender. By contrast, a loan agreement would be more complicated because it shows the promises of two parties – making the document more difficult to draft and more difficult to understand.
A third difference between a loan agreement and promissory note is that a promissory note is more often used in a consumer-type affair, whereas a loan agreement is used in the lending world. A promissory note is an easier and quicker way than a loan agreement to formalize a loan between friends or family members. However, for a business, a loan agreement is much more common as it helps the business and business owner to structure the terms of a risky type of deal involving debts and assets.
When Should You Use a Loan Agreement?
A loan agreement is more appropriate when there are complex terms or contingencies, when the transaction involves a corporate venture and/or where the lender is expecting to undertake more extensive due diligence and so wants additional protection for his investment.
In addition, where the lender is a bank, individual investor, insurance company or pension fund, they will want a loan agreement. For example, if you were to borrow a few thousand dollars from a friend, then you can probably get away with using a promissory note to document the loan, as in that case it is likely that a simple promissory note would be satisfactory. Conversely, if you borrow money from an investor, bank, credit union or insurance company, you would need a loan agreement.
When Should You Use a Promissory Note?
A promissory note is appropriate in a variety of contexts. It is likely the best choice for loans between family members, as it is easy and inexpensive to prepare, and is not intimidating to your parent or child, as it is far less formal than a loan from a bank or other financial institution. For parents loaning money to a child, a promissory note is the best option to memorialize terms of the transaction as it will capture the details of the loan and the promise to pay, without going through the extensive approval process of a bank. It can also be used between siblings, when money is being loaned to cover education expenses or purchase equipment such as a car. Similarly , if you are loaning money to your spouse to start a business, or loaning money to a friend, a promissory note is a simple, less formal option than a loan agreement.
A promissory note is also useful for more formal business relationships and transactions. If you are selling equipment from your business to a third party customer on an installment basis, a promissory note is appropriate to ensure your customer will make all of the required payments. If you are a contractor doing work on a residential rental property, you may be purchasing equipment and materials, and loaning them to your customer until your job is complete. In these situations, a promissory note fits nicely into the transaction.
Enforceability and Legal Considerations
The legal enforceability of both a loan agreement and a promissory note varies based on the contract’s specifics, yet the fundamental nature and function of both are the same. Their primary intention is to evidence a debt and provide the lender(s) with recourse should the borrower(s) default. By longstanding commercial practices, loan agreements generally contain more detailed terms held in higher regard. But that doesn’t necessarily make them more enforceable in a court.
If a borrower fails to comply with the terms of either a loan agreement or a promissory note, the lender can move for a breach of contract action. The hurdle that lenders must clear first is to establish that the debtor has failed to meet their obligations.
After that, although it’s generally easier to prove the case with a loan agreement, a lender can still prevail on a breach of contract action with only a well-written promissory note. However, in practical business, a loan agreement is easier to enforce because many more provisions exist that address different potential pitfalls, including:
A promissory note, on the other hand, is typically contained in only one or two pages. Given its simplicity, a court will generally enforce or discount a promissory note on its face, without much consideration as to intent and the parties’ conduct following the transaction. By its nature, a loan agreement may be more likely to require that a lender demand compliance before seeking enforcement. A lender’s lack of action doesn’t preclude them from enforcing the terms in a court, but a court could use such information to determine the time period for which the lender sought to enforce the agreement.
In certain jurisdictions, a court could factor in evidence pertaining to the actions of the parties after the contract was executed. In Illinois, for example, a court can look to the parties’ conduct after the agreement was made to determine whether it’s appropriate to enforce the terms of the contract. This includes a court’s discretion to consider whether the lender demanding repayment waited a reasonable amount of time before doing so and whether the lender demanded repayment or filed a lawsuit over the issue in a timely fashion. Regardless of the time period in which the lender enforces the provision or whether the lender formally demanded compliance, both a loan agreement and a promissory note are generally enforceable in a court. In most cases, the power of judgment won’t be afforded based on the type of contract presented. This is because both agreements represent the presence of a debt, and both are afforded the same, or substantially similar legal treatment.
Tips for Deciding Between a Loan Agreement and a Promissory Note
When deciding whether to use a promissory note or a loan agreement, consider a few practical tips and factors:
● What is the amount of money being loaned? If the amount is relatively small, a promissory note may suffice. A promissory note is a simpler document than a loan agreement, and depending on the circumstances may be a much easier document to prepare.
● What is the relationship between the parties? If the parties have a long-standing relationship and trust each other, it may be sufficient for the borrower to sign a promissory note. However, if the parties do not know each other well or the debt is significant, a loan agreement may be more appropriate due to its relatively greater rigour.
● What is the complexity of the transaction that the parties are entering into? If the transaction is complex or the lender will be extending other financial assistance (e.g., a mortgage or line of credit), a loan agreement can provide the necessary protection for the lender by ensuring that all relevant covenants, representations, warranties, terms and risk allocation are included. A promissory note does not contain those kinds of protections.
● Are additional documents such as guarantee and security documents required? If a lender is getting those additional documents , a promissory note may suffice. Including a loan agreement with a number of additional provisions may force the lender to delete the financial covenants if the borrower is only signing a promissory note and a guarantee (without signing the loan agreement as well as the guarantee).
● Is timely repayment of the debt vital to the ongoing business of the lender or is the money being lent only a very small sum? If the borrower is likely to repay the loan in full in accordance with the terms and has a track record of doing so, a loan agreement may not be needed. In these circumstances, a promissory note may be sufficient. However, if the lender does not need to receive repayment immediately, a promissory note may satisfy the lender’s needs. For example, if a bank wants to extend money for a house repair, a promissory note would probably suffice.
● How long is the loan? A promissory note should certainly suffice for a loan that is not more than two years. The shorter the term, the more likely it is that a promissory note would be sufficient. For example, a loan to a friend of a thousand dollars for a coffee machine would probably suffice. However, there should be caution with an unsecured loan greater than $25,000 for a loan longer than two years. Such a loan is probably too long and too substantial to be secured only with a promissory note.
In general, borrowers should want to ensure that lenders are secured for their loan grant and that any loan agreement or security takes precedence over a promissory note. In addition, lenders should be cautious about not limiting the borrower’s ability to borrow more money while the loan is outstanding.