Lending or borrowing money can be risky. You can reduce this risk with written documentation that sets out the terms of the loan. However, it is important to use the right type of document when borrowing or lending money. Both a promissory note and loan agreement set out a debt between parties and describe the terms of repayment. However, each is suitable for different types of loan. This article explains the essential differences between a promissory note and loan agreement.
What is a Promissory Note?
A promissory note sets out the terms where one party (the issuer, or borrower) agrees to pay a set monetary sum to another party (the payee, or lender). It is usually a simple document. A promissory note typically specifies the:
- amount of the loan;
- interest rate;
- maturity date; and
- late fees or penalties.
A promissory note is typically one-sided, only imposing obligations on the borrower.
When Should You Use a Promissory Note?
Promissory notes are best used for small transactions. For example, lending money to a friend or family member. In such cases, more complex documents may not be necessary. Even so, it is always best to have at least something written down, making a promissory note a great option.
However, if a promissory note contains intricate clauses, it may be considered a complex financial instrument. In this case, it would need to adhere to the regulations under the Corporations Act 2001 (Cth). Therefore, it is important to ensure that the clauses of your promissory note are not overly complex.
What is a Loan Agreement?
A loan agreement is a contract between the lender who agrees to provide a loan to the borrower. The terms of loaning the money are set out in the loan agreement. The loan agreement allows either party to prove the existence of the loan and enforce the terms of the loan if necessary.
A loan agreement is typically more complex and sophisticated than a promissory note. Each loan is different depending on surrounding circumstances. However, a loan agreement usually contains four sections:
|Section of Agreement||What it Contains|
|Definitions and Interpretation||Defines specific terms used to interpret the document|
|Financial or commercial details||States the loan amount, repayment amount and dates and interest payable|
|Transaction-specific details||Provides details such as representations of the borrower and what happens if the borrower defaults on the loan|
|Boilerplate||Sets out all the standard clauses used in all loan agreements, for example, the process for amending the agreement|
When Should You Use a Loan Agreement?
In circumstances where you need to borrow or lend a large amount of money such as putting a deposit down on a house, a loan agreement may be useful. As a loan agreement ensures the enforcement of the included terms, if necessary, it provides both parties with a reassurance that the lender will loan the money and the borrower will return the money.
For example, in the event of default, a lender may be able to exercise their contractual rights. Or, if a borrower does not pay back the money as per the time stipulated in the agreement, a lender may be able to charge late fees.
While both a promissory note and loan agreement set out the terms of a debt, they are each suited for different circumstances. A promissory note is a simple document to ensure a paper trail when lending or borrowing a small amount of money, particularly to or from someone you know.
Comparatively, a loan agreement is complex. It is suitable for loans that involve a substantial amount of money. Your circumstances will ultimately dictate what document is best to use.
If you need assistance drafting either a promissory note or loan agreement, call LegalVision’s contract lawyers on 1300 544 755 or fill out the form on this page.
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