Understanding Promissory Notes for Small Businesses
Learn about the different ways a promissory note can structure repayment of a business loan.
A promissory note sets out the repayment terms when you borrow money. There are several ways to structure repayment -- all with advantages and disadvantages. It pays to learn the ins and outs of each repayment plan type so that you can choose the best method for your business.
When Should I Use a Promissory Note?
If you borrow start-up cash for your business from a commercial lender, the lender will require you to sign a promissory note. You should also use a promissory note when borrowing money from a friend or relative. Documenting the loan can do no harm, and it can head off misunderstandings about whether the money is a loan or gift, when it is to be repaid, and how much interest is owed. It also documents the terms of the loan in case the IRS comes sniffing around with a business audit.
For downloadable forms, check out Nolo's Promissory Notes for Lending and Borrowing Money.
Types of Repayment Schedules
Banks provide their own promissory note forms. If you borrow from a friend or relative, you'll need to use a promissory note from form books or software. The legal and practical terms of promissory notes can vary considerably, but the most important thing is to pick a repayment plan that's right for you. Following are four different approaches.
1. Amortized Payments
With amortized payments, you pay the same amount each month (or year) for a specified number of months (or years). Part of each payment goes toward interest, and the rest goes toward principal. When you make the last payment, the loan and interest are fully paid. In legal and accounting jargon, this type of loan is fully amortized over the period that you make payments. (You've probably dealt with an amortized repayment schedule before, when paying off a car loan or a mortgage.)
Once you know the terms of the loan (the amount you want to borrow, the interest rate, and the time over which you'll make payments), you can figure out the amount of the payments using software such as Intuit's Quicken or Quickbooks, or an online calculator. Or you can use a printed amortization schedule, which is widely available from commercial lenders, business publishers, and local libraries.
2. Equal Monthly Payments and a Final Balloon Payment
This type of repayment schedule requires you to make equal monthly payments of principal and interest for a relatively short period of time. Then, after you make the last installment payment, you must pay the remaining principal and interest in one large payment, called a balloon payment.
Because of the lower monthly payments during the course of the loan, you can keep more cash available for other needs. Of course, when you're thinking about those nice low payments, don't forget the big balloon payment waiting around the corner.
Balloon payments can have extra risks. If you plan to take out a new loan when it's time to pay the balloon payment, you're gambling that interest rates will stay the same or go lower over the life of the loan. And if you're buying an asset (such as a building) that you plan to sell quickly to pay off the loan before the balloon payment comes due, you're gambling that the asset will not depreciate.
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.
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.