What is the Difference Between a Loan Agreement and Promissory Note?

Both a promissory note and loan agreement between a borrower and a lender are contracts that act as evidence of a debt owed from the former to the latter. But they aren’t the same thing. To understand how they’re different, you need to know what each of these entails. Let’s take a closer look to decode their difference.

Loan agreement

It’s used to record and set out the terms of a loan, which could be a personal loan or a business loan. A loan agreement contains the terms between the borrower and the lender along with the payback terms, the late fees and penalty applicable on delayed or non-payment respectively, and other general contractual terms. A loan could be between individuals, or corporations, or between a corporation and an individual.

Usually, the governing law of a loan agreement is the law of the jurisdiction where such an agreement has been entered into. Often, the parties involved in a loan choose the jurisdiction of which the lender is a resident. In case the loan agreement is related to the purchase of particular assets, the location of such assets is selected as the jurisdiction.

As a borrower, some of the key terms to consider include:

  • Interest provisions: You’ll be charged a certain percentage of the amount borrowed as interest, which is applicable for the term of the loan agreement. It’s important to negotiate to try and get an interest rate that’s as low as is possible.
  • Terms of repayment: You should ensure that the repayment terms of the loan are specified clearly. Additionally, you’ll need to understand them fully and know the exact amount due on each repayment date. 
  • What constitutes a default: It’s important for you to know what constitutes a default and what the consequences would be in the event of a default. Additionally, you’ll want to limit the scope of relevant defaults, in case it’s at all possible to do so.   

As a lender, you’ll need to ensure your loan agreement is watertight, is drafted accurately to suit the type of loan in question, and is supported by the correct security documentation.

Promissory note

It’s a written promise with agreed-upon terms between a borrower and a lender where the former promises to repay a sum of money to the lender. Usually, promissory notes are used when the amount lent isn’t huge or the lender lends money to someone close such as friends or family. But sometimes, you may even use it for large purchases where you can’t pay the entire purchase price upfront and promise instead to pay the remainder at a later date.

To create a promissory note, you’ll need the following information:

  • Contact information of the borrower and lender
  • Principal loan amount and the rate of interest (in case it’s being charged)
  • Length of loan or if it’s payable on demand
  • Frequency and amount of payment
  • Optional collateral
  • Grace periods, if any, allowed for payment
  • Penalty for late payment or default

While drafting a promissory note, both the parties involved should be aware of any “usury” laws in their jurisdiction, as it decides the maximum interest rate the lender can charge. In case usury laws are violated, it would result in civil and sometimes, even criminal consequences. As a lender, you should also consider whether you want to have security for the loan. Opting for it could help you recoup your money should the borrower declare bankruptcy.

Key differences

Despite setting out the terms of a debt, both a loan agreement and promissory note are suited for different circumstances.

  1. A loan agreement is usually for formal situations

You can have a loan agreement for everything – from a house or car to new business ventures and mortgages. Most banks and other reputable financial institutions use specific loan documents for particular situations (home loan, vehicle loan, business loan, etc). In contrast, promissory notes are usually used in cases of small loans, or short-term loans, or where the money is lent to friends and family.

  • Loan agreements are generally much more complex

Loan agreements are usually more complex, longer, and have extremely specific terms and clauses than promissory notes. But this doesn’t mean promissory notes can never be as complex. It’s just that generally, they’re the less complex among the two.

If you need help in deciding which one among the two suits your needs better, reach us now!

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