What Is A Loan Note And How Does It Work?
A loan note is a useful method of raising funds for any number of purposes. It’s a legally binding contract that acts as an IOU between a borrower and one or more lenders. The document stipulates the duration of the loan along with any agreed interest that’s payable.
The Loan Note Defined
A loan note evidences a debt between a borrower and lender, clearly setting out the loan’s terms and conditions to ensure that all concerned parties have their interests protected. A well-drafted promissory note will include contractual penalties should either the borrower or lender renege on their financial obligation.
In essence, it’s a form of promissory agreement that’s used for a wide range of purposes. Such purposes can include owner-managed businesses seeking investment, startups in need of seed money, and individuals hoping to secure a ‘big ticket’ purchase such as a new car or property.
The latter examples are deemed to be ‘installment loans’. When purchasing a home, it’s common that a lender will insist upon the existence of a promissory note to accompany the mortgage or deed of trust. This also applies to car financing or any other kind of installment loan.
How Does It Work?
Typically it’s the lender who completes a promissory note with the aim of properly framing and securing the debt. However, the borrower also benefits from having the conditions of the loan formally put in writing should anything go awry.
The process begins when the lender formulates the note document and submits it to the other party for approval. By doing this, they’re known as the ‘note holder’ or ‘subscriber’.
Upon taking receipt of the proposal, the borrower (issuer’) is advised to have a specialist study the small print before committing. If an agreement is reached, two forms of documentation are drawn up. The ‘loan note instrument’ is usually a single page document laying out the loan’s terms and conditions. The ‘loan note certificate’ is official evidence of the agreement signed by both the subscriber and issuer.
Elements Of A Loan Note
The key components of a typical note document will include the names and contact details of both parties in addition to the principal balance of the loan. It’ll also contain the interest rate that’ll run for the loan’s lifespan. Additionally, it’ll also state whether the interest rate is fixed or variable.
A predetermined repayment schedule lies at the heart of any loan note instrument. There should be a pre-agreed end-date, asserting when the loan is due to be paid off in full. This is called the ‘maturity date’ and once it occurs the loan note is naturally no longer valid.
Lastly, penalty clauses for late payment will usually be inserted. In some instances, prepayment penalties are stated should the issuer pay off the debt ahead of its full term. If the loan is secured, a record of any collateral being used will also be included.
Loan Note Benefits
There are many upsides to promissory notes. This is true for an individual who’s entering the property sphere or for a company that’s looking to raise capital. Let’s start with its most appealing aspects.
- A big tax hit can be avoided when a promissory note is chosen in lieu of a cash lump-sum
- With a minimal interest rate applied, businesses often use loan notes when trading. Again, this is an attractive alternative to a one-off payment and can be an arrangement that suits both parties
- They’re straightforward and relatively simple to construct. In its simplest terms, this is an IOU note. Accordingly, startup businesses turn to them as a practical way to secure seed capital
- These notes are incredibly versatile. Some are transferable while others can even be traded on the stock market. They can be used for secured and unsecured loans. Moreover, they can be used in all arrangements, no matter how large or small
Loan Note Considerations
Overall, there are undoubtedly more pros than cons when it comes to promissory notes. Even so, there are always caveats. While the following factors aren’t necessarily negatives, they should still be taken into account.
- The regulatory and tax status will depend on the circumstances involved. There are a few hard rules that apply across the board
- A promissory note may have similarities to an informal IOU but this is a legally binding contract that’ll be upheld by a court of law.
- Such agreements can only be voided if either party can prove the document was signed under duress
Loan notes can be specifically tailored for any given loan. These formal IOUs are designed to ensure that both parties know exactly where they stand.
Even though they’re ideal for individuals and startup businesses, it’s always advisable to still seek out expertise before committing pen to paper.