In every lending arrangement, the borrower is obligated to repay the borrowed funds within a specified timeframe. In these instances, a promissory note assumes a vital role. Promissory notes have been extensively employed in business transactions to guarantee the payment for goods or services.
What is a promissory note?
A promissory note, also known as a note or a demand note, is a written agreement committing to repay a debt. It serves as a legal and financial instrument, binding the borrower to repay the specified amount to the lender at the agreed-upon time or upon demand.
Promissory notes are negotiable instruments, payable on demand or in installments, as a lump sum, with or without interest. They can take various forms, including those with single or joint borrowers. In India, promissory notes can be issued under Section 4 of the Negotiable Instruments Act, 1881, with no prescribed limit on the amount that can be borrowed for the issuance of a promissory note.
Promissory Note: Significance
A promissory note confirms the validity of the lender and validates the creditworthiness of the borrower, as it promises the repayment of the loan or credit that has been lent.
A promissory note itself is unconditional, and it is only conditional to the parties specified, the lender and the borrower. Thus, the note is a negotiable instrument in the money market. The notes are considered securities and traded on the money market in India through banks and traders.
What does a promissory note contain?
A promissory note is enforceable only if it includes all the required elements, such as:
- Names of all parties: The Promissory Note should contain the legal names of all the involved parties in the transaction.
- Contact details of all parties: It should include the address and contact number of all parties.
- Amount of loan: The note should specify the loan amount being borrowed or lent.
- Repayment date: The date at which the borrower must repay the amount should be clearly mentioned in the note.
- Interest rate: If interest is being charged, the rate of interest, which will be calculated based on APR (annual percentage rate), must be specified in the note.
- Final amount after addition of interest: If interest is being charged, the note should mention the final amount that the borrower should repay after the interest is applied. The final amount will include the principal loan amount and the interest rate applicable.
- Collateral hold/pledge of security agreement: The list of goods or services being put as a guarantee on the loan and their value should be clearly mentioned in the document.
- Repayment terms: The terms on which the repayment of the loan must be made, with inclusions for late or missed payments, should be mentioned.
- Default terms: The terms applicable if the borrower fails to repay the loan on time should be clearly specified in the note.
- Signature: The note should contain the signature of the borrower and a witness, without which the note will be considered invalid, even in a court of law. The requirement of the lender’s signature may differ from state-to-state.
Types of promissory notes
A promissory note can be categorised as a secured or unsecured notes.
Secured notes work more like secured bank loans. The borrower must provide collateral, such as property, goods, services, etc., if they fail to repay the amount. The value of the collateral must be more or equal to the amount being borrowed.
In the case of an unsecured promissory note, the borrower does not have to provide any collateral. The loan can be provided if the borrower has a healthy credit score.
Promissory notes: Points to remember
- The note should be stamped by revenue stamps according to the Indian Stamp Act.
- It should be written by hand with all required elements.
- A promissory note issued in one Indian state can be presented in another state if it bears a valid stamp. There is no need to pay additional stamp duty.
- After issuance, a promissory note should be stamped based on the regulations of the Indian Stamp Act. A revenue stamp is commonly used on the note, which is signed by the promissory and/or cross-signed by the borrower.
- The note can be issued on a stamp paper if revenue stamps are unavailable.
- There is no maximum limit on the amount that can be lent or borrowed using a promissory note.
- Once the loan amount is disbursed or has been fully repaid, the promissory note should be cancelled and marked as ‘Paid in Full’, after which it may be returned to the borrower or payee.