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Understanding Promissory Notes for Small Businesses
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3. Interest-Only Payments and a Final Balloon Payment
With an interest-only loan, you repay the lender by making regular payments of only interest over a number of months or years. The principal does not decrease. At the end of the loan term, you must make a balloon payment to repay this principal and any remaining interest.
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The obvious advantage of this arrangement is the low payments. And, if you find yourself in the happy situation of having extra cash, you can usually prepay principal. But over the long term, you'll pay more interest because you're borrowing the principal for a longer time. For instance, on a $20,000 loan, paid back in four years, you would pay almost $3,000 less by making equal amortized payments than if you made interest-only payments plus a final balloon payment.
4. Single Payment of Principal and Interest
Some loans, especially those from friends and family members, don't require regular payments of interest and/or principal. Instead, you pay off the loan all at once, at a specified future date. This payment includes the entire principal amount and the accrued interest. Borrowing money on these terms is best for a short-term loan, or if the lender isn't worried about on-time repayment. You are not likely to get this kind of deal from a commercial lender.
Read the Fine Print
No matter which repayment method you choose, be sure to read your promissory note and any other loan documents carefully. Promissory notes provided by commercial lenders in particular usually contain all kinds of legalese and scary waivers of legal rights.
One example: Make sure you can prepay the loan without paying a penalty -- some states allow a lender to charge you a fee (which is really designed to compensate the lender for the loss of future interest) for prepaying the loan. For more on these issues, read The Lowdown on Business Loans.
If you need to draft your own promissory note using one of the above repayment plans, get Nolo's Quicken Legal Business Pro software or Legal Forms for Starting & Running a Small Business, by Fred Steingold (Nolo). In addition to providing you with the forms and instructions for creating a promissory note, both the software and book offer a security agreement to go with the promissory notes, if collateral will be required.
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