Promissory notes are simply documents that record a promise to pay back money that you've been loaned at a certain interest rate over a set period of time. There are many ways to structure promissory notes, and each one has its advantages and disadvantages. To figure out which form of promissory note will work best for you, it pays to learn more about each type and how it can help and hurt your business.
When to Use Promissory Notes
The bottom line is that you should always reduce any loan down to writing in the form of a promissory note. It doesn't matter if the loan comes from a bank or your best friend, it's important to get it in writing to avoid any misunderstandings and to protect yourself in case you are audited by the IRS.
Promissory Note Repayment Schedules
Banks will provide their own promissory note, but if you are getting a loan from a family member or friend, you need to use promissory forms provided by self-help books or software that that comply with the law in your state. Here are four basic ways to structure a repayment schedule on a promissory note:
- Amortized payments: Amortized schedules are probably the most common form of repayment and most people are familiar with them even if they don't use the name. Under an amortized payment schedule, you pay a set amount each month for a specified period of time, with part of the payment going towards interest and part of the payment going towards the principal (the original amount of money in the loan). Over time, you pay down the interest and principal until the debt is extinguished. This type of payment is common when paying off car and house loans.
- Single payment: Depending on the amount and source of the loan, some people choose just to pay off the loan in one big payment. The payment covers both the principal and interest, and the date to pay it off is usually set well into the future - by which time the business expects to have enough money on hand to simply pay off the entire balance of the loan. Commercial lenders will almost never allow for this kind of repayment, so single payment systems are far more common amongst family and friends.
- Monthly payments with a final balloon payment: With this form of repayment, the person receiving the loan pays smaller monthly payments for a period of time until the remainder of the loan is due in one big balloon payment. The advantage of this kind of loan is that you owe lower monthly payments initially (compared to amortized payments) which can really help some businesses avoid a cash crunch just as their business is getting started.
- Interest-only payments with a final balloon payments: Under an interest-only form of repayment, your monthly payments go only towards the interest. By the end of the loan term, you will have paid off the interest, but you will still owe a large balloon payment on the principal. The advantage to this is that it results in even lower monthly bills than the other forms of repayment. The disadvantage is that you will ultimately be paying more money in the long run because you're borrowing the principal for a longer period of time. For example, on a $20,000 loan over four years, you might end up paying as much as $3,000 more with an interest-only repayment schedule.
Understand What you Sign
Many people who take out loans, even otherwise savvy business people, can sometimes be surprised by what they find in the fine print of a promissory note. Even if a loan package seems like a good deal, take the time to really read the fine print and discuss anything you don't understand with an attorney. A common example of the kind of "surprise" that many business owners discover when they read the fine print is that many promissory notes apply a penalty if the debtor tries to pay off the loan early.
Obtain Legal Advice
If you are thinking of borrowing money for your new business, know the laws and be sure you are clear about how promissory notes work. If you have questions, contact a skilled business law attorney in your area who can help guide you through the loan process.