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Understanding Promissory Notes

(Also called "Loan Agreements" or "Contracts")

1. What's A Promissory Note

2. Understanding Interest Rates

3. Idea Cafe Tips

1. What's A Promissory Note

Down through the centuries, IOU's have been written on everything from papyrus to stone to paper napkins. A promissory note is simply the modern version: a formal promise to pay back money borrowed, in the form of a signed agreement between the lender (such as a bank) and the borrower (an individual or business).

The promissory note, also called a loan agreement, a contract, or simply the "note," spells out the terms of the loan that both parties have agreed to. The usual terms include:

  • Amount of the loan
  • Interest rate
  • Payment schedule
  • Due Date
  • Collateral
  • Discounting (if any)
  • Compensating Balance Requirements (if any)

2. Understanding Interest Rates

The interest rate is the percentage of the loaned amount the lender will charge you.

Two loan terms that can affect the effective interest rate are discounting, and a compensating balance.

Discounting a note means that the interest is subtracted from the principal upfront. but the borrower must pay back the entire amount although only the principal minus the interest is received. For example, if you borrow $500,000 at a 10% discounted rate. You receive $450,000, but are required to repay $500,000. this results in a higher effective rate of interest than the stated rate. Luckily, discounted rates are not used as often as they used to be.

A compensating balance requirement means the borrower must maintain a checking account (or other account) balance at the same lending institution at a specified minimum level. For a line of credit, for example, a bank may require a compensating balance of 10% of the line plus 10% of the borrowings. Because a chunk of your cash is sitting at the bank's disposal, earning little or no interest, this requirement also raises the effective interest rate of the loan. Compensating balances are most likely to be required for loans or lines of credit of more than $500,000.

3. Idea Cafe Tips

Read the promissory note or loan agreement carefully to avoid surprises. Pay particular attention to the default terms -- what happens if you don't make the payments as agreed -- payment terms and effective interest rate deserve particular attention. In fact, to be sure you find out the true bottom-line cost, run the agreement by your CPA before you sign it.

Anytime you borrow money from an individual -- even if it's just good old mom -- write up a little agreement. Make it look official: it is (whether you put it on paper or not, so cover your bases to avoid misunderstandings). Just list the amount being borrowed, the interest rate, the payment terms, and schedule. For these private loans, ask your CPA what the current permissible rate of interest is, since if you set a rate below what the IRS considers legit, you may end up having to pay the higher rate they require anyway (plus possible penalties all around). In other words, you can't cut a deal the IRS won't bless -- if the interest rate is too low, the IRS may consider the loan a "gift" and come looking to collect gift tax.

As with any business contract, run it by your attorney before signing anything. What you may save in accidental legal catastrophes will be well worth the hour or so of legal advice up front. Be clear on the interest rates when borrowing money from friends or family members. The IRS may treat interest-free loans as gifts that can incur taxes.



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