If you are considering loaning money to – or borrowing money from – another business or individual, it’s a good idea to set out some of the key terms in writing, to ensure that you’re both aware of your rights and obligations under the arrangement. Even in the situation where lender and borrower are well known to each other, adding an element of formality can help to prevent unnecessary misunderstandings and can often reduce any potential disputes arising further down the line. Furthermore, if a relationship breaks down, having an official agreement in place ensures that the lender has a legal recourse available and is not left out of pocket. Two of the most useful legal documents which establish a lending arrangement between two businesses or individuals are loan agreements and promissory notes.
When should I use a loan agreement?
A loan agreement is typically used when one business loans money to another business, where a substantial sum of money is involved. All types of business can use this type of agreement: limited companies, partnerships and LLPs and sole traders. Not only does it provide legal protection to the borrower but it also affords a level of certainty to the borrower. Its terms may include:
- the amount of the loan
- the repayment date – and any repayment schedule
- any interest payable under the loan
- if the loan is secured or unsecured, and
- any obligations and restrictions on the borrower
Whether or not a loan is secured is often a crucial term. This can, for example, mean that the borrower puts up their house or some other valuable assets as collateral; if they default on repayments, the lender may be able to force a sale of these assets in order to reclaim the debt. However, loan security is a tricky area and it’s a good idea to Ask a lawyer for advice to ensure that it’s enforceable.
When should I use a promissory note?
If a full blown loan agreement seems a little too formal, a promissory note can be used instead. This is often helpful when the loan is between two private individuals and the sums of money involved are relatively small – but it can also be used by businesses. A promissory note is essentially an unconditional written promise to repay a loan or other debts. Although it’s legally enforceable and can include many of the terms of a loan agreement, it’s generally designed to be more flexible and rarely includes an element of security. It’s a step up from a simple IOU, but not quite as onerous as a loan agreement.
For further information read Loan agreements and promissory notes.