Understanding Promissory Notes

Whether take out a loan from a bank or borrow money from someone you know, you should sign a promissory note.

If you borrow start-up cash for your business from a commercial lender, the lender will require you to sign a promissory note that sets out the repayment terms. If you borrow the money from a friend or relative, it's still smart to sign a promissory note, even if the lending friend or relative assures you that such formality isn't necessary. Documenting the loan can do no harm, and it can head off misunderstandings about whether the money is a loan or gift, when it is to be repaid, and how much interest is owed. It also documents the terms of the loan in case the IRS comes sniffing around with a business audit.

Types of Repayment Schedules

Banks provide their own promissory note forms. If you borrow from a friend or relative, you'll need to use a promissory note from form books or software. The legal and practical terms of promissory notes can vary considerably, but the most important thing is to pick a repayment plan that's right for you. Following are four different approaches.

1. Amortized Payments

You've probably dealt with an amortized repayment schedule before, when paying off a car loan or a mortgage. You pay the same amount each month (or year) for a specified number of months (or years). Part of each payment goes toward interest, and the rest goes toward principal. When you make the last payment, the loan and interest are fully paid. In legal and accounting jargon, this type of loan is "fully amortized" over the period that you make payments.

Once you know the terms of the loan (the amount you want to borrow, the interest rate, and the time over which you'll make payments), you can figure out the amount of the payments using software such as Intuit's Quicken or Quickbooks or an online calculator. Or you can use a printed amortization schedule, which are widely available from commercial lenders, business publishers, and local libraries.

2. Equal Monthly Payments and a Final Balloon Payment

This type of repayment schedule requires you to make equal monthly payments of principal and interest for a relatively short period of time. Then, after you make the last installment payment, you must pay the remaining principal and interest in one large payment, called a balloon payment.

Because of the lower monthly payments during the course of the loan, you can keep more cash available for other needs. Of course, when you're thinking about those nice low payments, don't forget the big balloon payment waiting around the corner.

3. Interest-Only Payments and a Final Balloon Payment

With an interest-only loan, you repay the lender by making regular payments of interest only over a number of months or years. The principal does not decrease. At the end of the loan term, you must make a balloon payment to repay this principal and any remaining interest.

The obvious advantage of this arrangement is the low payments. And, if you find yourself in the happy situation of having extra cash, you can usually prepay principal. But over the long term, you'll pay more interest because you're borrowing the principal for a longer time. For instance, on a $20,000 loan, paid back in four years, you would pay almost $3,000 less by making equal amortized payments than if you made interest-only payments plus a final balloon payment.

4. Single Payment of Principal and Interest

Some loans, especially those from friends and family members, don't require regular payments of interest and/or principal. Instead, you pay off the loan all at once, at a specified future date. This payment includes the entire principal amount and the accrued interest. Borrowing money on these terms is best for a short-term loan, or if the lender isn't worried about on-time repayment. You are not likely to get this kind of deal from a commercial lender.

Read the Fine Print

No matter which repayment method you choose, be sure you read your promissory note and any other loan documents carefully. Promissory notes provided by commercial lenders in particular usually contain all kinds of legalese and scary waivers of legal rights. For instance, make sure you can prepay the loan without paying any kind of penalty -- some states allow a lender to charge you a fee (which is really designed to compensate the lender for the loss of future interest) for prepaying the loan.

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