What is a promissory note?

Articles > Contracts

What is a promissory note?

June 5, 2021         openlegal

A promissory note is, simply, a written instrument under which the issuer (or maker) unconditionally promises to pay an agreed sum to the payee. This payment can be made at a fixed time or a time to be determined in the future, or on demand of the payee.

Promissory notes are negotiable instruments and can be useful for transactions which involve a relatively low sum of money between parties who have a close relationship. Once a promissory note is signed and dated, the issuer will be legally obligated to abide by its terms.

What key information should a promissory note contain?

Promissory notes should contain the following key terms:

  • Who the issuer(s) and payee(s) are (i.e. the parties) in relation to the payable sum;
  • When the sum is repayable;
  • Details of interest payable on the sum (if any);
  • Transferability of the note to another party (if any); and
  • The signature of the issuer or maker.

This list of terms is non-exhaustive. However, promissory notes which contain complex clauses may be regulated under the Corporations Act 2001 (Cth) as a complex financial instrument and can lead to different rights, responsibilities and liabilities being incurred (such as licensing and disclosure).

How does a promissory note differ from a loan agreement?

As mentioned earlier, promissory notes are not to be confused with loan agreements. While they are both used in situations where someone plans to borrow a sum of money and later repay it, loan agreements are much more complex.

Loan agreements are primarily used in situations that involve a substantial sum of money. They require the issuer (‘the borrower’) and payee (‘the lender’) to sign and date the document to impose legal obligations on both parties. Generally, a loan agreement will contain more complicated terms than a promissory note, including:

  • The purpose of the loan;
  • Conditions that the borrower must meet (if any);
  • Whether the borrower should provide compensation if the lender suffers loss;
  • Elaborate repayment terms (e.g. repayment in instalments over a certain period of time); and/or
  • ‘Events of default’ which would cause the loan to be paid immediately.

Lenders are provided with greater protection under loan agreements, so a detailed and complete loan agreement may be preferable in situations where protection and clarity is required.

When should you use a promissory note (rather than a loan agreement)?

Promissory notes are useful options to have proper documentary evidence of the sum owed to or by you. When it would take too much time, effort or cost to negotiate and draft a loan agreement but you would still like a paper trail, simple promissory notes are highly appropriate. However, they should only be used when you are promising to pay a fixed, relatively low amount of money, and when the transaction is low-risk. For example, a promissory note may be applicable when you are lending $1,000 to a family member to pay for a car. However, for high-risk, high-sum transactions in which you are dealing with an unfamiliar party (e.g. a bank), you should consider drafting a comprehensive loan agreement.

Regardless, consulting a legal practitioner is your best option if you have either borrowed money from someone, or have lent money to someone. As mentioned previously, including complex clauses in a promissory note may cause it to fall within the scope of certain regulations. Therefore, having a lawyer review your note will be useful to determine its appropriateness.

Critical takeaways

Promissory notes are simple, straightforward written instruments that are useful for smaller sums of money between closer parties. As promissory notes do not offer much protection for the person owed money (‘the payee / lender’), it may be more appropriate in certain circumstances to develop a comprehensive loan agreement. Loan agreements are more complex and provide more terms and conditions to the repayment, but they ensure that each party is owed certain obligations.

If you are unsure about whether a promissory note or a loan agreement is more appropriate for your circumstances, or need assistance drafting either, contact OpenLegal on 1300 337 997.

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