Promissory Note vs. Loan Agreement: What’s the Difference?

Jennifer Park
Published: December 15, 2022 | Updated: April 18, 2024

Promissory notes and loan agreements are documents that outline the details of a loan. They both outline the terms of the loan, including repayment terms, and act as legal documentation with remedies should a loan go unpaid.

Although promissory notes and loan agreements are similar, there are key differences between the two.

For example, promissory notes are typically created between you and someone you have a business or personal connection with. Loan agreements are typically created between you and the financial institution providing the loan. Read on to learn more about the differences between promissory notes and loan agreements.

What Is a Promissory Note?

In the simplest terms, a promissory note is a note in which you promise to pay someone. If you borrow $5,000 from your parents, friends, or a colleague, they’ll likely want something in writing that shows you acknowledge that you’ve received the loan and you agree to pay it back at some point.

Terms on promissory notes are usually fluid. You may agree to pay the loan back in one lump sum or over a series of installment payments. These notes don’t typically include remedies like late or return payment fees that you would find on traditional loan agreements either.

Promissory notes should include:

The loan amount
The date on which the loan should be repaid (if a lump-sum payment is required)
The dates on which installment payments should be made (if installments are allowed)
Interest or fees the borrower must pay to access the money
Any other terms the parties involved agree upon

When Can I Use a Promissory Note?

You can use a promissory note in various situations, such as:

When you need a simple and quick way to borrow or lend money, without involving a bank or a formal loan contract. A promissory note can be drafted and signed by the parties in a matter of minutes, and it does not require any collateral or registration.
When you want to defer the valuation of your company or business, and raise funds from investors without giving up equity. A promissory note can be convertible, meaning that it can be exchanged for shares or stock options at a later date, based on certain conditions or triggers.
When you want to clarify the terms of a loan that you have already made or received, such as the interest rate, the repayment schedule, the maturity date, and the consequences of default. A promissory note can serve as a legal evidence of the debt and protect the rights and interests of both parties.

Pros and Cons of a Promissory Note

Pros of a Promissory Note

Flexibility for Both the Borrower and the Lender: The parties can customize the terms of the note, such as the amount, interest rate, maturity date, payment schedule, and collateral, according to their needs and preferences.
Speed and Convenience for Obtaining Financing: A promissory note does not require a complex process or extensive negotiations to create and execute. It can be a simple and straightforward document that can be prepared and signed quickly.
Preserving the Borrower-lender Relationship: A promissory note can formalize the loan agreement and clarify the expectations and obligations of each party. This can reduce the potential for misunderstandings, conflicts, or disputes that may arise from an informal or verbal arrangement.
Tax Benefits: The borrower may be able to deduct the interest paid on the promissory note from their taxable income, depending on the purpose and use of the loan. The lender may be able to defer the taxes on the interest income received from the promissory note until the note is fully paid or forgiven.
Building Credit: A promissory note can show the borrower’s credit history and repayment behavior, which can affect their ability to borrow money in the future. If the borrower makes timely and consistent payments on the promissory note, they can demonstrate their creditworthiness and reliability to potential lenders.

Cons of a Promissory Note

Risks Involved: If the borrower fails to pay the promissory note as agreed, the lender may have to take legal action to enforce the note and collect the debt. This can be costly, time-consuming, and uncertain.
Limited Recourse: A promissory note can have limited recourse for the lender if the borrower declares bankruptcy or becomes insolvent. This is because the note is usually an unsecured debt, meaning that it is not backed by any collateral or assets. If the borrower files for bankruptcy or becomes unable to pay their debts, the lender may have to compete with other creditors for a share of the borrower’s remaining assets, which may be insufficient to cover the loan.

Inflexibility: As a binding contract, a promissory note cannot be easily modified or terminated without the consent of both parties. If the borrower or the lender wants to change the terms of the note, such as the interest rate, the payment schedule, or the loan amount, they may have to renegotiate the note or create a new one, which can be difficult or impractical.
Could Negatively Affect the Credit of the Parties: A promissory note can affect the credit of the borrower and the lender if the loan is reported to the credit bureaus. However, this depends on how the loan is handled and reported.

If the borrower misses or makes late payments on the promissory note, their credit score may drop and their credit report may show negative marks. If the lender reports the loan as income or forgives the debt, they may have to pay taxes on the amount and their credit report may show a charge-off or a write-off.

What Is a Loan Agreement?

A loan agreement is a more traditional legal document that outlines the details of a loan, much like a promissory note. The difference is in the details. You would normally sign a loan agreement with a financial institution; there’s a strong chance you’ve already done so in the past.

Any time you get an auto loan, mortgage, or even a personal loan through traditional means, your lender will request that you sign a loan agreement.

Loan agreements typically include:

The loan amount
The date on which installment payments are expected and
The amount of the installment payments
Details about the collateral (if any)
The interest the borrower is expected to pay
Any and all applicable fees
Any and all applicable terms
Legal remedies the lender may take if the borrower should default on the loan

When Can I Use a Loan Agreement?

A loan agreement may be suitable for certain situations, including the following:

When you need a complex and detailed loan agreement that covers various aspects of the transaction, such as collateral, covenants, representations, warranties, and remedies. A promissory note may not provide enough protection or flexibility for the parties, especially if the loan is large, risky, or long-term.
When you want to transfer or assign the loan to another party, such as a bank, a financial institution, or a third-party investor. A promissory note may not allow such transfers or assignments, or may require the consent of both parties, which can limit the liquidity and marketability of the loan.
When you want to keep the loan confidential or private, and avoid disclosing it to the public or the authorities. A promissory note may need to be registered or filed with the relevant agencies, depending on the type and purpose of the loan, which can expose the parties to taxes, fees, or regulations.

Pros and Cons of a Loan Agreement

Pros of a Loan Agreement

Access to Funds: Perhaps the most significant advantage is the access to capital. Whether for personal use, expanding a business, or financing large purchases, a loan can provide the necessary funds that might not be otherwise available.
Credit Building: Regularly paying off a loan can help in building or improving one’s credit score. A higher credit score can lead to better terms on future loans, including lower interest rates.
Budget Management: Loans come with predictable payment schedules, which can make budgeting easier. Knowing the exact repayment amount each month helps in managing finances more efficiently.
Potential Tax Benefits: In some cases, the interest paid on certain types of loans, like mortgages or student loans, may be tax-deductible. This can reduce the overall cost of borrowing.

Cons of a Loan Agreement

Interest and Additional Costs: Borrowing money isn’t free. Interest, along with possible fees (such as origination fees, late payment fees, and prepayment penalties), can significantly increase the total amount to be repaid.
Long-term Commitment: Many loan agreements span years or even decades. This long-term financial commitment can impact your budget and financial flexibility, limiting your ability to allocate funds to other areas.
Risk of Over-leveraging: Taking on too much debt can jeopardize financial stability. If the cash flow or income is not sufficient to cover repayments, it can lead to financial strain or default, affecting credit and financial health.
Collateral Risk: Secured loans require collateral, such as a home or car. Failure to make payments could result in the loss of the collateral, which could be catastrophic, especially if the collateral is a primary residence or essential asset.

Promissory Note vs. Loan Agreement

Promissory notes and loan agreements are somewhat similar documents. However, when you dig into the details, you’ll find more differences than similarities.

Differences Between Promissory Notes & Loan Agreements

Some of the most significant differences between promissory notes and loan agreements include:

Collateral: Most loan agreements center around loans with collateral, while promissory notes are only secured by the borrower’s word.
Repayment Terms: Promissory notes might require lump-sum repayment. However, in some cases, installment payments are allowed. In most cases, loan agreements come with monthly installment payments.
Parties: Most loan agreements are signed between a borrower and a financial institution, while promissory notes are signed between friends, family, and colleagues. This means promissory notes are easier to adjust if all parties agree.
Failed Payments: Promissory notes typically don’t give the lender a remedy if the borrower fails to pay. Loan agreements give the lender the opportunity to foreclose on the collateral if the borrower doesn’t pay as agreed. As a result, the only remedy for promissory note holders may be to file a lawsuit in an attempt to collect.
Legality: Promissory notes are only legally binding on the borrower’s side of the note. Loan agreements legally bind all parties involved.

Similarities Between Promissory Notes & Loan Agreements

Although there are plenty of differences between promissory notes and loan agreements, there are a couple of similarities that are worth mentioning. Those include:

Loan Amount: Promissory notes and loan agreements both clearly outline the total principal amount of the loan.
Payment Terms: Promissory notes and loans both clearly outline how the loan is expected to be repaid.
Interest & Fees: Both types of agreements clearly state the interest and fees the lender expects the borrower to pay.
Enforceability: Promissory notes and loan agreements are both legally enforceable. That means if the borrower fails to pay the lender as agreed, the lender can decide to settle things in court.

Do I Need Both a Promissory Note and a Loan Agreement?

In certain financial contexts, having both a promissory note and a loan agreement can be crucial to effectively manage and secure the transaction. Here are some situations where employing both documents might be necessary:

Complex Transactions

In complex loan arrangements, such as those involving large sums of money or intricate payment structures, utilizing both a promissory note and a loan agreement ensures that all terms are clearly defined and legally enforceable. The promissory note acts as the borrower’s unconditional promise to repay the debt, while the loan agreement details the broader legal framework governing the relationship between the parties. This includes clauses on defaults, remedies, and other legal protections that might not be present in a promissory note. Such detailed documentation is essential in business transactions or commercial loans where the stakes and risks are higher.

Loans Involving Multiple Parties

When a loan involves multiple lenders or beneficiaries, a comprehensive loan agreement alongside a promissory note can help manage the complexities. The loan agreement can delineate the responsibilities and rights of each party, handling aspects like the distribution of payments or the division of collateral rights. This arrangement prevents misunderstandings and conflicts among the parties involved, ensuring smooth operation and clear communication.

Secured Loans

For loans that are secured by collateral, both a promissory note and a loan agreement are typically necessary. The promissory note establishes the borrower’s promise to repay the loan, while the loan agreement provides detailed terms regarding the security interest — specifying what collateral is pledged, the conditions under which it might be seized, and the rights of each party regarding the sale or disposition of the collateral.

Regulatory Compliance

Certain loans, especially those within regulated sectors like banking or corporate finance, may require stringent documentation to comply with legal standards. Both a promissory note and a loan agreement are often required to meet these regulatory demands. The loan agreement provides a detailed record of the transaction that can be scrutinized for compliance with laws and regulations, while the promissory note serves as a clear, concise declaration of debt.

Using both documents in these circumstances enhances the clarity and enforceability of the loan terms and provides a robust framework for managing the loan throughout its lifecycle.

Final Thoughts

Although promissory notes and loan agreements are similar in some ways, they’re also very different. It’s important to understand these similarities and differences before entering either type of agreement, whether you’re the borrower or the lender.

Related resources

Cited article sources

Dept.org (Updated February 23, 2022). “What is a Loan Agreement” https://www.debt.org/credit/loans/contracts/