A promissory note is a debt instrument. It is used to borrow money from private lenders usually. It works similarly to a bank loan with both parties agreeing on the repayment terms. Additionally, it can take the form of a secured or unsecured debt instrument.
It is a written agreement for the borrowed money. It can work as a negotiable instrument and can be traded. The lenders expect interest rate returns and can also use it as a trading instrument before the maturity date.
What is a Promissory Note?
A promissory note is a written agreement to pay (by the borrower) a specific amount on maturity date to the second party (the lender). The borrower of the money is the issuer of the note. Financial institutes and banks issue it to obtain financing. However, large companies and private borrowers can also issue a promissory note.
It must contain the specific amount borrowed, the duration, interest rate, and maturity date. The note must also include the terms and conditions on the payment and default on the borrowed money.
It comes with an option of one lump sum repayment. In some cases, the lender may ask for regular repayments over time with a specified interest rate.
How Does Promissory Note Work?
It works as a tool for short-term financing for large companies. It usually comes without any collateral and works on the creditworthiness of the issuer. The note works as a debt instrument in the form of a written agreement.
Companies issue promissory notes for the working capital requirements. It is issued to a lender with a promise to make the repayment with (or without) interest on a specified date. For companies facing working capital management issues, it offers a good cash alternative. Companies can secure a short-term financing option by issuing a promissory note. The creditors can also secure good returns on the debt through interest.
The issuer can pledge an asset to make it a secured debt instrument. Usually, it does not offer the same level of financial security as a bank loan. It does not offer recourse rights to lenders. However, it does contain legal implications for the borrower and default may result in a litigation process against the borrower.
The most common use of it is to obtain short-term financing by large companies. It issued by large entities with credible financial history can work as a tradable instrument. As it offers returns through interest and confirms a repayment on a specified date, traders can use it as a negotiable trading instrument.
Important Points with a Promissory Note
It can be unconditional and unsecured or conditional and backed by collateral. The creditworthiness of the issuer plays an important role as well. It issued by a credible company will be easily available for trading on the secondary market.
A promissory note is usually backed by the creditability of the issuer. However, is less secure than a traditional bank loan. A bank loan provides the rights to recourse to the lender in the case of the borrower’s default. On the other hand, it does not offer the right to recourse. In the case of the borrower’s default, the lenders cannot seize any assets owned by the borrowers. However, the borrower may face strict litigation in case of a default.
Here are some other key points in a Promissory note:
- A promissory can be issued by an individual, company, or financial institute to raise capital.
- It must contain the terms of the borrowed money such as the specific amount, interest rate, payment time, maturity date, etc.
- Regulatory authorities need to monitor the notes issued by large companies to assess their creditworthiness.
- It is a riskier option than bank loans, also offers higher returns due to the higher default risk of the borrower.
- It can be secured or unsecured by a collateral pledge.
- The notes are contractual and legally binding agreements between the borrower and the lender.
Important Types of Promissory Notes
It can take various forms with different characteristics and uses.
Commercial Promissory Notes
Commercial notes are issued by companies looking to raise financing. The issuers of the promissory notes pay higher interest on the borrowed money than a bank loan. The negotiating nature of the instrument means creditors can use promissory notes as a trading instrument as well.
Real Estate Promissory Notes
It’s a common practice in the real estate industry to issue promissory notes with a property deal. The property buyers sign a note that defines their payment terms, tenure, maturity date, and interest rate.
Investment Promissory Notes
Promissory notes offer higher returns than a bank loan. These notes can be traded on the secondary market. Thus, investors can use the instrument as an investment option and trade promissory notes with favorable prices.
The notes can also be categorized according to the repayment plan.
- A lump sum repayment
- Due on demand
- Repayable on installments
- Due on maturity
Advantages of Promissory Notes
It can be used as a source of financing by the issuers mainly. However, it comes with other advantages as well:
- It is a good source of short-term financing for borrowers.
- It can be issued by individuals, companies, corporations, and financial institutes.
- The notes can be used as a source of financing as well as investment options.
- It can be secured or unsecured.
- It can be traded on the secondary markets by investors.
Disadvantages of Promissory Notes
The notes offer alternative financing options to the borrowers and come with many benefits. However, the notes have their limitations as well.
- Promissory notes require the high creditworthiness of the issuer to attract investors.
- Investors are at a higher risk of default than in a traditional bank loan.
- Promissory notes usually do not come with recourse rights.
Conclusion
Promissory note offers a useful capital financing option to the issuer. It can be issued with or without collateral. These are tradable debt instruments on the secondary markets. However, it is a less secured debt instrument than a bank loan.
