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What is a Promissory Note?
A promissory note is a document or statement containing a promise from one party to another. This note states that the note’s issuer will pay a predefined sum of money to the noteholder. Usually, it also includes the maturity date or the date on which this transaction will occur. However, some notes may also have terms for payment on-demand.
A promissory note is a method for borrowers to obtain finance without going through a rigid process. These notes make it more straightforward for borrowers to obtain finance. Apart from the date and sum of money, promissory notes also include other terms. These may consist of interest rate, date, and place of issuance, penalties, etc.
Promissory notes are legally binding documents that create an obligation for a party. Usually, these notes are prevalent among smaller companies and individuals. Sometimes, however, financial institutions or larger companies may also issue them. Through these notes, issuers can obtain loans from institutional lenders. This way, issuers can get loans from almost anyone or any source.
How do Promissory Notes work?
When seeking to obtain a loan, issuers will have many options. The most prevalent choice is to acquire funds through financial institutions or institutional lenders. However, this may not be an option sometimes. Therefore, borrowers may need to look for other lenders. For any loans obtained through these lenders, borrowers can issue a promissory note.
As mentioned, a promissory note is simply a document that contains a promise to repay. These notes can be as simple or as complex as the borrower and lender decide them to be. For example, a note payable may include the amount to be repaid or a repayment schedule for multiple installments. Although these notes create an obligation for the borrower, they are more flexible compared to loan contracts.
Promissory notes also contain various elements, some of which may be optional. Any promissory note always includes the name of both parties, their signatures, and the amount of the loan. On top of these, it may contain the interest rates, the terms of the loan, any collateral used, the repayment process, etc. Lastly, promissory notes may also involve on-demand payments. However, those are less common.
Promissory Note Example
A small company, Orange Co., wants to renovate its office building. However, it does not have sufficient funds to do so. Being small, Orange Co. cannot raise capital through financial institutions. Therefore, it must go for other options. Orange Co. identifies another company, Blue Co., that is willing to provide it with a loan. Since it is a small amount of loan, both companies decide to skip a loan contract.
Instead, Orange Co. issues a note payable to Blue Co., stating that it promises to repay the loaned amount. The promissory note also contains the date on which Orange Co. will repay the loan and the interest rate for the length of the loan. Both companies sign off the note. Once the repayment date arrives, Orange Co. repays the loaned amount and the interest payable on it.
Conclusion
A promissory note is a document that states an issuer’s promise to repay a lender at a specific date. It creates an obligation and is a type of debt instrument. Promissory notes contain all the terms related to the loan transaction between two parties. Similarly, these notes are more flexible compared to loan contracts or other formal loans.
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