Financial lending and borrowing between family and friends is done on the basis of trust. However, the terms of such financial transactions are often unclear, which may lead to confusions regarding the payback of the loaned amount. This can end up straining the relationship between the involved parties.
What is a Promissory Note?
A Promissory Note is a unique financial instrument which binds the borrowers by law to pay the lender the specified sum of money at a specified date or on demand. Promissory Notes are negotiable instruments issued under the Negotiable Instruments Act and can be of different types, such as with single or joint borrowers, to be paid on demand or on installments, payment to be made in a lump sum, with interest or without interest.
Types of Promissory Notes - Secured or Unsecured
A Promissory Note may be secured or unsecured. In case of a secured note, the borrower will be required to provide a collateral such as property, goods, services, etc., in the event that they fail to repay the borrowed amount. The value of the collateral being provided must be more or equal to the amount that is being borrowed. N case of an unsecured Promissory Note, no collateral needs to be provided. An unsecured loan is easy to get if one has a health credit score.
Compulsory elements of a Promissory Note
A Promissory Note will only be enforceable if it includes all the elements which are necessary to make it a legal document. To make a Promissory Note enforceable, I must contain the following information.
Names of All Involved Parties -the Promissory Note must include the legal names of all the parties who are a part of the transaction.
Contact /Address Details of All Parties - The note must include the address and contact number of all the parties which are involved in the transaction.
Loan Amount - The loan amount that is being borrowed or lent.
Date of Repayment - The note must clearly state the date on which the repayment for the loaned amount must be paid.
Rate of Interest - In case interest is being charged on the lent or borrowed amount, the note must mention the rate of interest which will be calculated on the basis of APR (annual percentage rate).
Final Amount After Addition of Interest - In case interest is being charged, the note must clearly mention the final amount which is to be repaid after the interest is applied. The final amount will include the principal loan amount + the interest rate applicable.
Collateral Hold / Pledge of Security Agreement - the note must contain the list of goods / services which are being put as a guarantee on the loan and also their value.
Terms of Repayment - The note must have a clear mention of the terms on which the repayment of the loan must be done. Inclusions can also be made for late or missed payments.
Default Terms - The note must clearly mention the terms applicable in case the borrower fails to make the payment of the loan amount on time.
Signature - The note must compulsorily include the signature of the borrower and a witness. Whether the signature of the lender is a mandatory requirement will differ from state to state. However, the signatures of the borrower and witness are of prime importance as without them, the note will be invalid and not have any legal capacity in a court of law.
Important Points to Remember about Promissory Notes
- A Promissory Note is issued under Section 4 of the Negotiable Instruments Act, 1881
- Promissory Notes issued in one Indian state can be presented in another state provided that the note bears the valid stamp. There is no requirement for additional stamp duty to be paid.
- A Promissory Note must always be written by hand. It must include all the mandatory elements such as the legal names of the payee and maker’s name, amount being loaned / to be repaid, full terms of the agreement and the full amount of liability, beside other elements.
- The note must clearly mention only the promise of making the repayment and no other conditions.
- After issuance, a Promissory Note must be stamped according to the regulations of the Indian Stamp Act. The common practice is to use a revenue stamp on the note which is then signed by the promissory and/or cross signed by the borrower.
- A Promissory Note can also be issued on a Stamp paper in case revenue stamps are unavailable.
- The ideal way to lend money is via issuing crossed account cheques. Details of the cheques can be mentioned in the note.
- All Promissory Notes are valid only for a period of 3 years starting from the date of execution, after which they will be invalid.
- There is no maximum limit in terms of the amount which can be lent or borrowed.
- The issuer / lender of the funds is normally the one who will hold the Promissory Note. When the loan amount has been disbursed or repaid fully, the Promissory Note must be cancelled and marked as “Paid in Full”, after which it can be returned to the borrower / payee.
- While the signature of a witness is not a mandatory requirement, it is advisable to have a note signed by a witness who is independent from the transaction.