The Importance of a Promissory Note When Loaning Money

Have you ever heard the expression, “never loan money to family or a friend”? Loaning money to a friend or family member can create a sensitive situation and has broken many friendships as well as created family rifts. A person who loans money to someone else wants to make sure that the money they loan is paid back according to the terms agreed between the parties. Read on to learn the importance of a promissory note when loaning money.

Importance of a Promissory Note When Loaning Money to Family or Friends

If you loan money to a family member or friend, it is always recommended to have the agreement and understanding outlined in writing. You can do this by creating a legal document called a “promissory note”. This document is confirmation of the debt and makes sure that the borrower understands how the monies are to be paid back. What happens if the friend or family member to whom you are loaning money takes offense at the suggestion that they sign a promissory note? You can easily justify the importance of a promissory note when loaning money to a friend or family member by explaining that loans can have tax consequences. You simply need a written record in case should you be audited by the IRS.

Promissory Note vs IOU

A promissory note is not the same as an IOU (I owe you). Although An IOU acknowledges that money is owed, an IOU does not provide any details about 1) how the money will be paid back or 2) when it will be paid. The importance of a promissory note when loaning money is that it provides details of the amount of the debt, whether there is interest, the amount of interest, and the terms of how the debt will be paid back.

Secured and Unsecured Promissory Notes

A promissory note can be secured or unsecured. What is the difference between a secured promissory note and an unsecured promissory note?

Secured Promissory Note: The importance of a promissory note when loaning money that is “secured” is that the terms of the note gives the lender a “security interest” in property owned by the borrower. This property is also called “collateral” and can be personal property or real property. If the borrower does not pay back the money or comply with the terms of the loan repayment, the lender can take the collateral to repay the loan. One of the benefits of having a secured promissory note is for added protection if the borrower does not pay the loan as promised. The security interest ends when the debt is repaid.

Promissory Note Secured on Personal property: A promissory note can be secured on personal property. Personal property can be tangible or intangible. Tangible personal property is something that can be seen or touched, such as a car, a computer or a piece of jewelry. Intangible personal property includes patents, copyrights, trademarks as well as ownership rights in a business. Often when a note is secured by personal property, there is other documentation that will need to be prepared to formally establish the lien of the property, such as a UCC-1 filing or changing the pink slip on a vehicle to show a lien holder.

Promissory Note Secured by Real property: Real property consists of improved or unimproved land. If you want to secure a promissory note on real property, you will also need to prepare a Deed of Trust that is referenced in the promissory note. The importance of a promissory note when loaning money secured on real property is that you will have a mortgage lien on the property. This lien will protect you should the borrower default on their payments. The lien becomes recorded against the title and allows you to foreclose on the property should the borrower fail to pay the loan as agreed.

Unsecured Promissory Note: With an unsecured promissory note, the person loaning the money has no security interest in the borrower’s property. If the borrower does not repay the money loaned, the only recourse a lender has would be to file a lawsuit. If the lawsuit is successful, the lender may be able to put a lien on the borrower’s property or pursue other avenues of collection. Litigation and collection can be an expensive and lengthy process, and there is no guarantee that the lender will be able to recover all or part of the monies loaned.

Should You Charge Interest on a Promissory Note?

When dealing with family and friends, it may feel wrong to consider charging interest. Keep in mind that one of reasons to charge interest is to maintain the value of your money against inflation. Charging a modest amount of interest should not bother the borrower very much and will make sure that you do not lose money due to inflation rates. The importance of a promissory note when loaning money allows you to clearly define whether interest will be charged and if so, what the rate of interest is.

Many people believe they can charge any amount of interest the borrower is willing to agree to. Unfortunately, that is not the case. Each state limits on how much interest can be charged when money is loaned. In most circumstances, California restricts the interest individuals can charge to ten percent (10%) per year on a personal loan.

There are many exemptions to California’s usury laws. These exemptions can be found throughout various California code sections including the Civil Code, the Financial Code and the Insurance Code, etc. This makes California’s usury laws very complicated and difficult to understand. To be safe, don’t charge more than 10% interest on monies you loan.

Criteria For a Valid Promissory Note

A promissory notes can be customized to meet your agreement and needs of the parties. There are, however, certain essential elements of all promissory notes.

• In Writing – Promissory notes must be in writing. A promissory note is not a “verbal” agreement. It must be a written document signed by the borrower.
• For Money – A promissory note is a promise by one person or entity to pay money to another person or entity. A promise to give property (or property and money) is not a promissory note.
• Due Date – A promissory note identifies when payment is due. All promissory notes must have a specific due date or “payable on demand” clause. Payment cannot depend on an event. A promissory note must be unconditional, meaning that once signed, the only remaining thing to happen is the repayment of the amount due. If payment is “optional”, the promissory note is not valid.
• Specific Amount – All promissory notes must provide a specific amount that will be paid back to the lender. If the document provides the payment will be “$5,000 and other amounts owed,” the promissory note is not valid. This does not apply to interest that is part of the loan and that may be required by the note. If a promissory note merely states an interest rate but does not state exactly how much total interest will be paid over time, the promissory note is still valid.
• Transferable to Third Party – Promissory notes usually indicate they are “payable to order” or “payable to bearer.” This means the note is transferable from one person to another and could be payable to some unknown third-party in the future.
• Signature of Borrower – The person or entity representative that is borrowing the money must sign the note. It is not necessary for the lender to sign the note.

As you can see, the importance of a promissory note when loaning money to a friend, family member or other party is to formalize the agreement of the parties. Having a promissory note takes away any potential misunderstandings and keeps the transaction at arm’s length.  If you need help preparing a promissory note, whether it be an unsecured note or a note secured by deed of trust on real property, contact A People’s Choice. We can help prepare all necessary paperwork to make sure the terms of your arrangement are clear and contain all the requirements under California law.