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What is the Difference Between a Promissory Note and Loan Agreement?

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Last revision: June 18th, 2021
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Category: Commercial Activity
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It's likely you've made or received a loan at some point in your life. Even if you've never signed a formal document stating as much, you have probably granted a friend or family member's request to let them borrow a few bucks. You may have even done the same.

If you're a business owner, chances are higher that you've taken out a formal loan, with lots of paperwork involved. Most college graduates in the United States have student loans, which also involve official documents.

Even if you've never taken a loan out from a big financial institution, you may have used a simple document to make a larger loan to a friend or family member, like for them to buy a car. Perhaps your parents made a loan to you to help you buy your first house, and you memorialized the terms of the agreement in writing.

Agreements about money borrowing and payback can take a few different forms, but there are two that most people tend to think of: formal loan agreements and promissory notes.

What are the differences between these two types of loan documents? What are the similarities? Here, we'll discuss everything you need to know about loan agreements and promissory notes.

Please be advised that nothing in this guide is meant to constitute legal advice, and it should instead be taken as informational only.

What is a Loan Agreement?

First thing's first: what are these two documents, exactly? A Loan Agreement is a formal contract evidencing the loan of a certain amount of money from a lender to a borrower. There are several specific types of loan agreements, depending on what the loan is being given for. However, at its most basic level, this is a document that contains the terms between the lender and the borrower about the loan, the payback, the consequences of non-payment, and several other general contractual terms.

What is a Promissory Note?

A Promissory Note is a document from a borrower to a lender that basically says the borrower will promise (hence the name) to pay back a certain amount of money.

What are the similarities between loan agreements and promissory notes?

Although there are important differences between promissory notes and loan agreements, they have a few critical similarities that need to be discussed first.

1. They both describe a sum of money to be paid back.

The most obvious similarity between the two is that they are both documents about money that was loaned and needs to be paid back. This is the primary reason that some people think of these two documents as interchangeable.

Some large financial institutions even use the term "note" to describe their loan agreements.

Both of these documents can legitimately be used in any situation where money needs to be paid back, even if it is a large sum of money. But, the differences between the two documents make it slightly more clear when each should be used.

Final takeaway: Both promissory notes and loan agreements are, at their core, documents about a borrower that needs to pay back a lender for a specific sum of money.

2. They both usually cover the consequences of non-payment.

Neither a promissory note nor a loan agreement would be complete without including certain information about what should be done in case the borrower doesn't pay the lender back. Without this critical information, neither document would be worth much! If a loan agreement or promissory note simply stated that a borrower needed to pay back a lender with a certain amount of money, the lender's only recourse in the case of non-payment would be to take the borrower to court and argue about what the consequences should be there. It is much more efficient to clearly delineate what the borrower will have to face if they don't pay within the confines of the document itself.

Now, this doesn't mean that people never go to court over money that is not paid back; of course, this happens every day. But, since each of these documents usually contain clauses about penalties for the borrower in case of non-payment, the lender has a much clearer case to take to a judge.

Final takeaway: Loan agreements and promissory notes both usually contain information about what will happen in case the borrower does not pay the lender back.

3. They both bind the borrower.

Just like neither document would be worth anything if there weren't information about consequences, neither document would be worth anything if it didn't bind the borrower. "Bind" simply means legally tying a party to something they have to do. In this case, the party being legally tied is the borrower, and the thing they have to do is pay back the money.

Both a promissory note and a loan document bind the most important party to the payback terms, the borrower.

Final takeaway: Both of these documents are executed, or signed, by the borrower.

What are the differences between loan agreements and promissory notes?

Now that we're aware of the similarities between these two documents, let's talk about the differences.

1. Promissory notes are generally (but not always) used for more informal relationships.

In general, promissory notes are used for more informal relationships than loan agreements. A promissory note can be used for friend and family loans, or short-term, small loans.

Loan agreements, on the other hand, are used for everything from vehicles to mortgages to new business ventures. Most banks and other large financial institutions have specific loan documents that they use for specific situations.

Final takeaway: Promissory notes are usually used for less formal situations.

2. Promissory notes do not bind the lender.

As alluded to above, although both documents bind the borrower, only loan agreements also "bind" the lender. That's because the lender also signs a loan agreement, but does not sign a promissory note.

The word "bind" may, in fact, not tell the whole story here. Although the lender signs a loan agreement, as well, it's rare that they are actually binding themselves to any action. Instead, the loan agreement will have lots of information about the lender's rights in terms of the loan. Usually, the lender isn't promising to do something like the borrower is, but is instead signing in acknowledgment of the loan, as well as acknowledgment of their rights, which often include how to handle the situation if the borrower doesn't pay and what permissible options are available for dispute resolution.

Final takeaway: Lenders do not sign promissory notes, only loan agreements.

3. Loan agreements are usually much more complex.

Loan agreements are usually longer and more complex than promissory notes. They often have to be because of the very specific terms needed for large, complex loans. Most financial institutions, in fact, have several form clauses they use in their loan documents that have been written by attorneys over many years, honing the requirements for the loans, and adding more information as situations arise.

That isn't to say that promissory notes can't be complex, it's just that as a general matter, loan agreements are usually the more complex out of the two.

Final takeaway: Promissory notes are generally less complex than loan agreements.

Additional considerations

For people that may wish to use a document that is even more simple than a promissory note, an IOU can be used. An IOU is usually a really informal document that just outlines that one party owes money to the other. Often, even consequences of non-payment aren't included in an IOU which makes it the perfect document for evidencing a small, simple loan.

There are also additional, and more specific, loan agreements that should be used for certain things. For example, as touched on briefly above, a mortgage is a very specific type of loan against collateral (the home). Those agreements shouldn't be standard loan agreements and should instead be specific to their purpose.

Final takeaway

As you can see, although loan agreements and promissory notes do have some similarities, they are not exactly interchangeable documents. It's important to know the differences between the two so you can ensure you are using the right type of agreement for your needs.

As always, if you have specific questions, or are considering which document to use for a complex transaction, it's a good idea to check in with an attorney licensed in your state who specializes in this area. They would be in the best position to advise you on your individual needs.

 

About the Author: Anjali Nowakowski is a Legal Templates Programmer at Wonder.Legal and is based in the U.S.A.

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