What Is a Loan Note?

A loan note is an extended form of a generic I Owe You (IOU) document from one party to another. It enables a payee (borrower) to receive payments from a lender, possibly with an interest rate attached, over a set period of time, and ending on the date at which the entire loan is to be repaid. Loan notes are usually provided in lieu of cash at the payee's request.

A loan note denotes a type of contract that typically outlines the legal obligations of the lender and the borrower. A proper loan note will include a set of contractual penalties, including the right to sue or seek arbitration if either party to the contract fails to meet or otherwise defaults on financial obligations. 

Key Takeaways

  • A loan note is a type of promissory agreement that outlines the legal obligations of the lender and the borrower.
  • A loan note is a legally binding agreement that includes all the terms of the loan, such as the payment schedule, due date, principal amount, interest rate, and any prepayment penalties.
  • Lenders typically require borrowers to agree to loan notes for big-ticket purchases, such as for a home or car.
  • Loan notes can have tax benefits to the borrower and can also be a convenient source of seed money for new entrepreneurs and startups.
  • In many cases, a loan note is preferable to an informal IOU because a loan note holds more legal significance and is easier to uphold in court should there be a disagreement between the parties.

How a Loan Note Works

A loan note, a form of promissory agreement, includes all of the associated loan terms. It is considered a legally binding agreement with both parties considered committed to the terms as they are written. A loan note can be drawn up by either borrower or lender, though it is more traditionally completed by the lender. The note is considered valid until the amount listed on the document is paid in full by the borrower.

A loan note can help an individual avoid a tax hit due to a lump-sum payment from a settlement or cash-out package.

Information Contained in a Loan Note

The loan note contains all of the pertinent details regarding the legal agreement reached by the involved parties. This includes the names and contact information for both parties, as well as the principal balance and any interest rate being applied over the term of the loan. Additional information regarding the payment schedule, including the due date, will be included.

Penalty information may also be included. This can include repercussions for late payments or information pertaining to prepayment penalties.

While prepayment clauses serve as a protection to the lender against losing interest income over the course of the loan, the clause means the borrower will pay a penalty for paying down or paying off the loan during a specified time, usually within the first few years of the loan's start date.

Example of a Loan Note

Loan notes are used mostly for installment debts in which the borrower is making a purchase of a particular good or service and paying the amount back over time. A common consumer need for a loan note is a home purchase, which includes a loan note along with the mortgage or deed of trust. Loan notes are also used for vehicle financing and most other forms of installment loans.

Benefits of Loan Notes

A loan note can help an individual avoid an undue tax hit due to a lump-sum payment from a settlement or cash-out package from a company. In these cases, the individual is given a choice between cash or a loan note. When loan notes are used between businesses, the purchaser is able to act as a borrower and make payments over time, often at a minimal interest rate.

Loan notes can be fairly simple to draw up and convenient for both parties to implement with straightforward details. They can represent the first form of funding for young businesses. Startups and new entrepreneurs often use them to obtain seed capital from friends and family in order to establish a business.

Special Considerations for Loan Notes

Legally, a loan note holds more significance than an informal IOU, even when the informal IOU is notarized. Generally, a loan note will be upheld unless either party can prove the agreement was entered into while under duress, which may make the conditions within the document void, rendering them unenforceable.