If you buy real property with borrowed funds from the seller or a commercial lender, or borrow start-up cash for your business from a commercial lender, the lender will require you to sign a promissory note.
You should also use a promissory note when borrowing money from a friend or relative. 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 audits a transaction.
Banks provide their own promissory note forms. If you borrow from a seller (seller financing) the Seller’s attorney will usually prepare the note.
Following are four different approaches.
1. Amortized Payments-amorized loan
With amortized payments, 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. (You’ve probably dealt with an amortized repayment schedule before, when paying off a car loan or a mortgage.)
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 an online calculator. Or you can use a printed amortization schedule, which is 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. There will be a balloon payment waiting around the corner.
Warning Balloon payments can have extra risks. If you plan to take out a new loan when it’s time to pay the balloon payment, you’re gambling that interest rates will stay the same or go lower over the life of the loan. And if you’re buying an asset (such as a building) that you plan to sell quickly to pay off the loan before the balloon payment comes due, you’re gambling that the asset will not depreciate.
3. Interest-Only Payments and a Final Balloon Payment
With an interest-only loan, you repay the lender by making regular payments of only interest 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 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.
No matter which repayment method you choose, be sure to 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.
One example: Make sure you can prepay the loan without paying a 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. F