Promissory Note vs Loan Agreement: Which Do You Need?

Promissory Note vs Loan Agreement

When money changes hands as a loan, the parties need a written record of the transaction. Two documents dominate this space: the Promissory Note and the Loan Agreement. Both involve a promise to repay borrowed money, but they differ in structure, complexity, legal treatment, and the situations in which they are appropriate. Using the wrong document can leave a lender without adequate protection or burden a simple transaction with unnecessary complexity. This guide covers every meaningful distinction.

What Is a Promissory Note?

A Promissory Note is a written, unconditional promise by one party, the maker, to pay a specified sum of money to another party, the payee, either on demand or at a specified future date. The Promissory Note is a one-sided document. Only the borrower signs it. The lender's obligations, if any, are not set forth in the note itself.

A typical Promissory Note includes the principal amount, the interest rate, the repayment schedule, the maturity date, and the signatures of the maker. It may also include provisions for late fees, prepayment penalties, default, acceleration, and the governing law. Promissory Notes are intentionally concise, often fitting on one or two pages.

The most distinctive feature of a Promissory Note is its potential negotiability. Under Article 3 of the Uniform Commercial Code (UCC), a Promissory Note that meets certain requirements qualifies as a negotiable instrument. This means the note can be transferred to a third party, called a holder, who may acquire greater rights to enforce the note than the original payee had. A holder in due course takes the note free from most defenses that the maker could have raised against the original payee.

What Is a Loan Agreement?

A Loan Agreement is a bilateral contract between a lender and a borrower that sets forth the terms and conditions of a loan in comprehensive detail. Unlike a Promissory Note, a Loan Agreement is signed by both parties and contains obligations on both sides. The lender commits to making the loan available under specified conditions, and the borrower commits to repaying it according to the agreed terms.

A Loan Agreement typically includes the loan amount, interest rate, repayment schedule, conditions precedent to disbursement, representations and warranties by both parties, affirmative and negative covenants, events of default, remedies upon default, collateral and security interests, subordination provisions, and dispute resolution mechanisms. Loan Agreements can run dozens or even hundreds of pages in complex commercial transactions.

Loan Agreements are not negotiable instruments. They cannot be transferred with the same legal effect as a Promissory Note, and a transferee does not acquire holder-in-due-course status.

Key Differences

Simplicity vs Complexity

The Promissory Note is the simpler document. It captures the essential terms of the loan, the amount, the interest rate, and the repayment schedule, in a brief format. It is well-suited for straightforward transactions where the terms are few and the parties want a clean, enforceable record.

The Loan Agreement is the more complex document. It addresses not only the repayment terms but also the conditions under which the loan is made, the borrower's ongoing obligations during the term of the loan, the events that constitute default, and the lender's remedies. It is designed for transactions where the lender needs extensive protections and ongoing control over the borrower's activities.

One-Sided vs Bilateral

A Promissory Note is a unilateral promise. The maker promises to pay. The payee makes no promises in the note. The payee's only obligation, to disburse the loan proceeds, may be evidenced separately or may have already occurred.

A Loan Agreement is a bilateral contract. Both parties make promises. The lender promises to lend, subject to conditions. The borrower promises to repay and to comply with various covenants during the term of the loan. This bilateral structure allows the agreement to address the relationship comprehensively.

Negotiability Under UCC Article 3

A Promissory Note can qualify as a negotiable instrument under UCC Article 3 if it meets four requirements: it must be in writing and signed by the maker, it must contain an unconditional promise to pay a fixed amount of money, it must be payable on demand or at a definite time, and it must be payable to order or to bearer. A negotiable Promissory Note can be endorsed and transferred, and a holder in due course takes the note free from personal defenses such as fraud in the inducement or failure of consideration.

A Loan Agreement is not a negotiable instrument. It contains conditions, covenants, and obligations that destroy the unconditional nature required for negotiability. A Loan Agreement can be assigned, but the assignee takes it subject to all defenses the borrower could raise against the original lender.

Security and Collateral

Both documents can be secured or unsecured. An unsecured Promissory Note or Loan Agreement relies solely on the borrower's promise to repay. A secured transaction involves collateral that the lender can seize if the borrower defaults.

However, the mechanics of creating a security interest differ. A Promissory Note may reference collateral, but the security interest is typically created by a separate Security Agreement and perfected by filing a UCC-1 Financing Statement. A Loan Agreement often includes the security provisions within the agreement itself, along with detailed descriptions of the collateral, the borrower's obligations to maintain and insure the collateral, and the lender's rights upon default.

For real property collateral, a Deed of Trust or Mortgage is used alongside either document to create the lien on the property.

Default Provisions

Promissory Notes typically include basic default provisions. If the borrower fails to make a payment when due, the entire balance may be accelerated, meaning the full amount becomes immediately due and payable. Late fees may apply. The maker may be responsible for the payee's collection costs and attorney fees.

Loan Agreements include much more detailed default provisions. Events of default may include not only missed payments but also breach of representations and warranties, violation of financial covenants, cross-default with other obligations, material adverse changes in the borrower's financial condition, bankruptcy filing, and failure to maintain required insurance or collateral. The lender's remedies upon default are also more extensive and may include acceleration, foreclosure on collateral, appointment of a receiver, and the right to set off amounts owed against the borrower's deposits held by the lender.

Interest Rates and Usury Laws

Both documents must specify an interest rate that complies with applicable usury laws. Every state has a maximum interest rate that may be charged on consumer loans, and some states extend usury limits to commercial loans as well. The consequences of violating usury laws range from voiding the excess interest to voiding the entire loan, depending on the state.

Promissory Notes typically state a fixed interest rate or a variable rate tied to a published index such as the prime rate. Loan Agreements may include more complex interest provisions, including different rates for different tranches, default interest rates, interest rate floors and ceilings, and SOFR-based pricing with spread adjustments.

Truth in Lending Act

The federal Truth in Lending Act (TILA) and Regulation Z apply to consumer credit transactions. If the loan is made to a natural person for personal, family, or household purposes, the lender must provide specific disclosures including the annual percentage rate (APR), the finance charge, the amount financed, and the total of payments. These disclosures are typically provided alongside either a Promissory Note or a Loan Agreement but are not part of the note or agreement itself.

TILA does not apply to business or commercial loans. However, some states have their own commercial lending disclosure requirements.

When to Use Each

Use a Promissory Note When:

• The loan is simple with straightforward repayment terms\n- The transaction is between friends, family members, or close business associates\n- The loan amount is relatively small\n- The loan is unsecured or secured by a single asset with a separate security agreement\n- You want a concise, easily enforceable document\n- The lender may want to transfer or sell the note to a third party\n- The loan is a personal loan without complex conditions

Use a Loan Agreement When:

• The loan is large or complex, involving multiple tranches, conditions, or covenants\n- The lender needs ongoing control over the borrower's activities through financial covenants\n- The loan involves multiple pieces of collateral or complex security arrangements\n- The lender needs detailed representations and warranties from the borrower\n- The transaction involves a commercial loan between businesses\n- Multiple lenders are participating in the loan through a syndication or participation arrangement\n- The lender requires conditions precedent to disbursement, such as legal opinions, insurance certificates, or environmental assessments

Can You Use Both?

Yes, and in many commercial transactions both documents are used together. The Loan Agreement sets forth the comprehensive terms of the lending relationship, including all covenants, conditions, representations, and remedies. The Promissory Note serves as the evidence of debt, the instrument that the borrower signs promising to repay the loan according to the terms set forth in the Loan Agreement. In these transactions, the Loan Agreement controls in the event of any conflict with the Promissory Note.

Common Mistakes

• Using only a Promissory Note for a complex commercial loan that requires covenants, conditions, and detailed default provisions\n- Using a full Loan Agreement for a simple personal loan between family members, creating unnecessary complexity and legal expense\n- Failing to comply with usury laws, which can void the interest or the entire loan\n- Omitting an acceleration clause, which forces the lender to sue for each missed payment individually\n- Neglecting to create and perfect a security interest when collateral is intended to secure the loan\n- Failing to comply with TILA disclosure requirements for consumer loans

Summary

A Promissory Note is a concise, one-sided promise to pay that works well for simple loans. A Loan Agreement is a comprehensive, bilateral contract that provides the extensive protections needed for complex lending transactions. The right choice depends on the size of the loan, the complexity of the terms, the relationship between the parties, and whether the lender needs ongoing control over the borrower's activities. For significant commercial transactions, both documents are often used together.