Promissory note vs loan agreement

A promissory note is a written, unconditional promise by one person to pay a fixed sum to another, either on demand or on stated dates. The borrower signs it. The lender keeps it. It is signed by the borrower only, because the borrower is the one making the promise.

The note is itself the evidence of the debt. If the borrower stops paying, the lender does not have to prove that money changed hands under some wider arrangement. The lender produces the note. A note that names the parties, the amount, the rate, the payment dates and the maturity date is a complete instrument on its own.

Most notes are also negotiable instruments under Article 3 of the Uniform Commercial Code. That means the lender can sell or assign the note to someone else, and the new holder can enforce it on the same terms. A note that is payable “to order” or “to bearer”, for a fixed amount, with no conditions attached, qualifies. A note that says payment depends on some other event generally does not.

A loan agreement is a contract between the lender and the borrower. Both sign it. It describes the whole relationship rather than the single promise to pay. A typical agreement covers:

• Conditions the borrower must meet before the lender advances money, such as delivering a signed security agreement.
• Representations, which are statements of fact the borrower makes and stands behind, such as being solvent or owning the asset offered as collateral.
• Covenants, which are promises about conduct while the loan is outstanding, such as keeping insurance in force or sending annual financial statements.
• Events of default, which name what counts as a breach beyond a missed payment, and what the lender may do about it.
• How and when funds are advanced, which matters when the money comes in stages rather than all at once.

The agreement often refers to a note signed at the same time, and says that the note evidences the debt the agreement creates. The two are drafted to match. The agreement handles the conditions. The note handles the promise.

For most loans between people who know each other, a note is the right document. The lender advances the full amount on one day. The borrower repays on a schedule. There are no covenants to monitor and no staged funding to administer. A well-drafted note already contains everything a court or an accountant will ask for.

A note is usually sufficient when:

• The loan is funded in a single advance.
• The borrower is an individual, and the lender is a relative, friend or private investor.
• There is no collateral, or the collateral is handled by a separate security document.
• The only thing the lender needs to monitor is whether payments arrive on time.

A note of this kind should still carry a late fee clause, a prepayment clause, a governing law clause and an acceleration clause that lets the lender call the whole balance if the borrower defaults. Those are standard terms in a note, not reasons to add an agreement. The guide to what a promissory note must contain lists them.

Add a loan agreement when the relationship has moving parts that a promise to pay cannot describe. The common cases:

• Business borrowers. A loan to a company usually comes with covenants about financial reporting, limits on other borrowing, and restrictions on paying out distributions while the loan is outstanding. Those belong in an agreement.
• Staged funding. If the lender advances $50,000 now and $50,000 when a permit is issued, the agreement sets the conditions for the second advance. The note then evidences whatever has actually been advanced.
• Collateral with obligations. When the borrower pledges equipment, inventory or receivables, the lender wants covenants about keeping the collateral insured, in good repair and free of other liens.
• Guarantors or multiple lenders. An agreement can name who guarantees the debt and how several lenders share payments and decisions.

In each case the note stays short and the agreement carries the detail. Keeping the promise to pay in its own instrument preserves the note’s value as evidence and as something the lender can assign later.

A note can say the loan is secured by a car, and an agreement can say the borrower grants the lender a security interest. On their own, those sentences do not give the lender a claim on the asset that holds up against other creditors or a buyer. A lien requires its own paperwork.

• For personal property such as vehicles, equipment or business assets, the borrower signs a security agreement that describes the collateral, and the lender files a UCC-1 financing statement with the state. For a titled vehicle, the lien is usually noted on the title through the motor vehicle department instead.
• For real estate, the borrower signs a mortgage or a deed of trust, depending on the state, and it is recorded in the county where the property sits.

Without those filings, the lender is unsecured. That is acceptable for many family loans, where the lender is relying on the borrower rather than on an asset. It is not acceptable when the collateral is the reason the lender agreed to the loan.

When a loan has both documents, they must agree on every term they both state: the parties, the principal, the rate, the payment schedule, the maturity date, the late fee, the prepayment terms and the governing law. A conflict between the two is the most common drafting error in private loans, and it hands the borrower an argument in any later dispute.

The simplest discipline is to state the economic terms once, in the note, and have the agreement refer to “the Note” rather than restate the figures. If the agreement must repeat a term, copy it exactly. When terms change later, amend both documents on the same day, in writing, signed by the same people.

The borrower signs the note. Both parties sign the agreement. Each party keeps a complete copy of everything that was signed, with the date. Electronic signatures are valid for both documents under federal and state law, as the guide to electronic signatures on promissory notes explains.

Store the signed documents together with the record of what was advanced and what was repaid. When the loan is paid in full, the lender marks the note paid and returns it, or sends a written release, and files a termination for any lien. NoteHouse drafts the note from the terms you enter, collects both signatures, and keeps the signed copy with the ledger. The sequence is described on how it works.