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Tata Capital > Blog > Loan for Business > What Is a Promissory Note?

Loan for Business

What Is a Promissory Note?

What Is a Promissory Note?

There may have been times when just a spoken word was enough to bind people into financial commitments. However, today, you need a legally binding document to back up your commitment. A promissory note is one such document.

A promissory note is an indispensable financial instrument for various financial transactions. It provides a structured and legally binding means of acknowledging debt.

Read on as the article takes a deep dive into the features of promissory notes to help you understand how they work, their various types, and the repayment procedure.

What is a promissory note?

A promissory note is a document representing a commitment to repay a specified sum due to a loan or other arrangement. This signed document, issued by the debtor to the creditor, stands as a legally binding contract.

The note comprehensively outlines all the pertinent terms associated with the transaction, including the principal amount of the debt, the applicable interest rate, the date of maturity, and other crucial details. It also bears the issuer's signature, making the agreement binding and enforceable.

How does a promissory note work?

Now that the promissory note’s meaning is clear let’s understand how it works with an example.

Suppose Ram has borrowed a sum of Rs. 1 lakh from Shyam and has agreed to pay him back after 5 years.

However, a verbal commitment is insufficient for Shyam, as he demands a legally binding contract before lending the sum. So, Ram creates a promissory note highlighting all the details. It will include the borrowed sum, interest rates incurred, date of maturity, and the final sum to be paid at the end.

Since the promissory note is governed by the Negotiable Instruments Act of 1881 in India, it stands as a legally binding contract. Hence, if Ram does not stand by the contract, Shaym can take legal action against him.

What are some types of promissory note?

Depending upon their workings, promissory notes can be classified into secured and unsecured promissory notes.

Unsecured promissory notes have no collateral involved in the lending procedure. Hence, if the borrower defaults on loan repayment, the creditor has to follow a conventional debt-collection procedure.

Contrastingly, in the case of a secured promissory note, some asset is typically put up as collateral for the funds borrowed. If the borrower fails to repay their dues, the creditor assumes ownership of the collateral and can use it until the debt is repaid. Promissory notes used in real estate transactions are usually secured.

Promissory notes can also be categorized into various types based on their specific use and the nature of the lending agreement. These include:

1. Personal Promissory Notes

These are used for loans obtained from family or friends. Although formal legal documentation is often overlooked in such informal agreements, a promissory note can formalize the transaction, demonstrating trust and commitment between the parties. It is a tangible acknowledgement of the loan and the borrower's intent to repay, safeguarding both parties' interests.

2. Commercial Promissory Notes

Commercial promissory notes are used in transactions with commercial lenders, such as financial institutions. They resemble personal promissory notes in structure but are more formalized. These notes usually contain detailed terms and conditions, reflecting the more formal nature of these financial relationships.

3. Real Estate Promissory Notes

Used in property transactions, these notes carry significant consequences for nonpayment. In the event of default, the lender may have the right to retain ownership of the property until the debt is repaid. Defaulting on real estate promissory notes repayment can also take a hit on your credit score.

4. Investment Promissory Notes

These are occasionally utilized for business fundraising. Treated as securities, these notes are governed by securities laws and include specific terms regarding investment returns. They serve as a formal instrument for securing investment funds, detailing the terms under which investors will receive returns on their investment.

What are the contents of a promissory note?

In India, a promissory note typically encompasses the following elements:

1. Declaration: A clear statement that identifies the document as a "Promissory Note".

2. Unconditional Undertaking: A straightforward promise to pay a specific amount.

3. Involved Parties: Clear identification of the debtor and the creditor in the situation.

4. Amount: The sum to be paid, expressed in numbers and words to avoid confusion.

5. Repayment Details: Clear instructions regarding the date of maturity, repayment method, and place of payment.

6. Interest Information: If applicable, details of the interest rate. Interest amounts can be calculated from the day of lending or after a specified date.

7. Signature: Concerned parties must add their signature to the document, ensuring its legality and enforceability.

What does a promissory note’s repayment structure include?

The repayment structure of a promissory note typically includes the reimbursement of the principal amount along with accrued interest. Some of the most common repayment methods for a promissory note include:

1. Instalment Note

This is a commonly used repayment method where the borrower makes scheduled payments over time. The frequency and amount of these payments can vary depending on the agreed-upon terms. Typically, borrowers opt for monthly repayment options.

2. Simple Note

Suited for smaller loans, this method involves a lump-sum repayment on a predetermined date. Essentially, the entire amount outlined in the promissory note is paid back in one go. The final amount to be repaid depends on the interest component of the actual document.

3. Open-Ended Note

This flexible option allows borrowers to withdraw funds as needed from a designated loan, such as an operating loan. The borrowed amount and the interest are then repaid by a specified date.

4. Demand Note

In this arrangement, the repayment is made "on-demand," meaning the lender can request repayment at any time. This provides the lender with a high degree of flexibility regarding when they wish to have the loan repaid.

To sum up

India's financial framework relies heavily on various instruments, with the promissory note as a crucial component. Be it personal loans or corporate financing, promissory note's simplicity, versatility, and importance in monetary transactions cannot be overstated.

However, if you want to ditch the hassle of extra documentation and get business loans hassle-free, consider opting for Tata Capital’s business loans. With Tata Capital, you can access collateral-free business loans at a competitive interest rate and without extensive documentation. For more details, visit our website today.

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