Loan agreements and promissory notes (2024)

3 min read

What you'll learn:

What is a loan agreement?
What is a promissory note?
Should I use a loan agreement or promissory note?

Businesses and individuals occasionally need to borrow or lend money between themselves, instead of going to a financial institution, for a variety of reasons. A parent company may decide to provide funding for one of its subsidiaries during hard times, or a private individual may wish to help a family member who is setting up a new business and requires some capital investment. Whatever the reason for a loan between businesses or individuals, it is a good idea to record this as a written loan agreement or promissory note.

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What is a loan agreement?

A Loan agreement is a standard type of document that sets out the terms of a loan and its repayment. It should be used whenever a substantial amount of money is involved, particularly if the lender and borrower are not very closely linked or wish to keep things on a more formal footing. This agreement should be used by all types of small business, including companies, partnerships and LLPs, Scottish general partnership and Scottish limited partnerships (SLPs), and sole traders.

Some of the principal terms contained in a loan agreement include the amount of the loan, the date by which it needs to be repaid in full along with any agreed instalment dates, and details of any interest payable.

It is also possible to add security to a loan - in which case the borrower pledges their assets (such as a house or car) as collateral for the loan. It is recommended to Ask a lawyer for advice if entering into a secured loan, as some of the issues involved can be complex.For more information on secured loads, read Unsecured and secured loans.

What is a promissory note?

A Promissory note is essentially an unconditional written promise to repay a loan or other debts, at a fixed or determinable future date. Although it is legally enforceable, a promissory note is less formal than a loan agreement and is suitable where smaller sums of money are involved. However, its terms - which can include a specific date of repayment, interest rate and repayment schedule - are more certain than those of an IOU. As well as facilitating business to business lending, promissory notes can also be used by private individuals who wish to formalise debts and loans between each other.

Should I use a loan agreement or promissory note?

Both loan agreements and promissory notes are legally binding - and enforceable - documents which set out terms for the repayment of debts. However, a loan agreement normally contains more specific and stringent terms, with greater obligations and restrictions placed on the borrower. It also often includes elements of security (egputting up a house as collateral) whereas a promissory is typically unsecured.

As a general rule, if a relatively small amount of money is involved and there is a great deal of trust between the lender and borrower (or debtor), a promissory note should suffice. However, if there is a substantial debt involved and the two parties are not overly familiar with each other, a loan agreement is more advisable.

Rocket Lawyer's Loan agreement should be used when both parties are businesses or when an individual is loaning money to a business. ThePromissory note should be used when both parties are individuals (such as family members or friends).