Loan agreements and promissory notes

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 put this on a formal footing with a written loan agreement or promissory note. Having one of these legal documents in place ensures that both lender and borrower are aware of their rights and responsibilities and helps to avoid disputes or misunderstandings further down the line.

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What is a loan agreement?

A loan agreement is a fairly standard type of document which 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. All types of small business can make use of a loan agreement, including companies, partnerships and LLPs, 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.

If the loan is a personal loan (i.e. between two individuals) then the interest rate can be fixed at whatever interest rate the creditor feels is acceptable (within reason). Simple interest calculations are usually the most straightforward when charging interest. The simplest is a fixed amount over the term of the loan, for example, if someone borrows £4,000, you may charge £200 of interest to be paid back in equal instalments over 10 months (they pay £420 a month for 10 months for borrowing £4,000). If you are charging interest, it is taxable income and must be declared as such.

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. But it is recommended to Ask a lawyer for advice if entering into a secured loan, as some of the issues involved can be complex.

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. But 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 (eg. putting 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.

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