Loans and promissory notes are both financial instruments used to borrow money. Both types of instruments come with varying legal and formal structures.
Let us discuss what is a loan and a note, and their key differences.
What is a Loan?
A loan is a type of agreement between two parties where one party borrows money from the second one and agrees to repay the amount on certain terms and conditions.
A loan is a financial instrument that comes with discrete characteristics. It is an exchange of money between two parties where the borrower compensates the lender for lending money.
The lender receives this compensation in the form of interest or a finance charge. Both parties must agree upon these terms of a loan including the interest rate, loan term, repayment frequency, and collateral requirements.
A loan is a legally binding agreement between both parties. If the borrower defaults on the loan, the lender may pursue litigation against the borrower.
Individuals, companies, corporations, and government entities can make a loan agreement.
Components of a Loan
A loan agreement comprises some key components that define its characteristics.
This is the amount borrowed by one party from the other at inception. Loan terms and conditions revolve around this principal amount largely.
This is the length or cycle of a loan agreement. Depending on the type of loan, it can be a fixed date or a revolving term with auto-renewals until both parties abandon it.
This is the financial charge paid by the borrower to the lender as compensation for lending money. It can be a fixed or variable rate depending on the loan type.
It comes in the form of a pledged asset(s) and makes a loan secured. Unsecured loans are considered riskier as compared to secured loans.
It defines the monthly or quarterly repayments to the lender comprising the principal and interest components of the loan.
Types of Loans
A loan can be of different types depending on its characteristics and features.
Secured and Unsecured Loans
These loans are differentiated based on collateral. Asset-backed loans are secured and non-backed loans are unsecured. Secured loans are cheaper than unsecured loans.
Fixed and Variable Rate Loans
The interest rate charged on loan can be fixed or variable. Both types come with discrete pros and cons for both parties.
Revolving or Term Loans
A revolving loan offers open-ended access to the borrower to reuse the facility again without seeking approval every time.
These loans come from non-traditional resources like peer-to-peer loans, venture capitalists, pay-day loans, fast cash loans, etc.
What is a Promissory Note?
A promissory note is a type of financial instrument that comes with a written promise to repay the borrowed money.
Although it is not a legal contract it is still a legally binding document for both parties. Depending on the type of promissory note, the borrower may lose a pledged asset in case of a default on the promise.
Generally, a note lies between a formal loan agreement and an informally borrowed money arrangement. However, written consent in the arrangement makes a promissory loan a financial obligation.
Components of a Promissory Note
A promissory note comprises different components to shape its formal structure.
It is the principal amount borrowed by one party from the other. It is the face value of the money before adding a financial charge to it.
It is the compensation rate paid by the borrower to the lender. Like a loan contract, it can be fixed or variable.
It includes recording the starting and ending dates of the promissory note arrangement. It will define the term promissory note.
It includes recording the first payment date and a subsequent schedule of payments if there is more than one payment due.
It can include repayment of a lump sum amount too.
Details of Both Parties
A written promissory note must include the details of the borrower and the lender. Then, both parties must sign the document to formalize the deal.
Types of Promissory Notes
A promissory note can also be of different types depending on its features.
A simple note comes with a lump sum repayment structure. The repayment amount includes a finance charge on top of the principal amount upon maturity.
It becomes due when the lender demands repayment. Both parties must agree upon a notice period though.
Secured and Unsecured Notes
The presence of a pledged asset makes a promissory note secure or unsecured otherwise. Like a loan, secured notes are cheaper than unsecured ones.
These are formal arrangements made between businesses usually. These notes take the form of formal loans and come with rigid conditions.
Companies issue these notes to raise capital. These notes then become marketable securities and can be traded in the secondary market.
Loan v Note – Key Differences
A loan and a note come with discrete uses and features. Both parties enjoy different benefits with each financial instrument.
Here, summarize some key differences between a loan and a promissory note.
A loan is a formal and legal contract between two parties. It is backed by a higher degree of legal formalities. Therefore, a loan comes with a better legal enforcement structure.
A promissory note is less formal but also comes with a legal obligation. Although it is not as rigid as a loan, it still binds both parties legally.
Formality and Security Features
A promissory note is a written promise between both parties. However, it does not include a detailed legal terms and conditions structure.
On the other hand, a loan agreement includes more formalities in writing. Therefore, both parties are legally more secure in a loan arrangement.
The repayment terms of both financial instruments can vary. A loan and a promissory note can come with regular repayments or a one-time lump sum repayment.
Usually, loans are repaid gradually through monthly or quarterly installments. Contrarily, promissory notes usually come with a lump sum repayment arrangement.
Since promissory notes are informal arrangements, they cost less. However, lenders may charge higher interest rates as they often lend money for the short term and on short notice.
The cost of formal arrangements of loans is higher. The interest rates are regulated and controlled by central banking bodies somewhat.
Both types of financial instruments can be used for personal and business purposes. Then, they can be used to fulfill a financial need of any kind too.
An informal written promise may be used to buy a car or investment in a business. A loan can also be used to buy a home or fund a business need.
A default on secured financial instruments means the borrowers may lose pledged assets. A promissory note and a loan can both lead to litigation in case of a default on repayments.
Usually, a loan’s default consequences are rigid compared to a promissory note. However, it does not mean notes come without legal implications in case of a default.