Updated July 10, 2023
What is a Loan Note?
The term “loan note” refers to the contract between a lender and a borrower that clearly outlines the legal obligations of both parties involved in the transaction. It is also seen as the extended version of the IOU document between a lender and a borrower.
Typically, a loan note contains all the terms and conditions of a loan, including contractual penalties. As per the loan note, the lender agrees to extend the loan money to the borrower at a particular interest rate for a pre-determined period, while the borrower agrees to repay the entire loan at the end of the tenure.
How Does Loan Note Work?
A loan note represents a legally binding contract between a borrower and a lender, with both parties committed to the terms and conditions outlined in the document. Either the borrower or lender can draw it up. Typically, either party can invoke the right to seek arbitration, as stated in a typical loan note, if they fail to meet any contractual obligations. In most cases, the lenders invoke the loan notes to recover their money when the borrower defaults.
When a loan note is signed, it is considered that both borrower and lender have read the entire document and agree to the legal terms and conditions cited in the note. Both parties should have notarized copies of the signed and original loan note. Given the stringent legal conditions, they should document all the transactions, disbursals, and repayment with a receipt.
As mentioned below, a loan note can use for various purposes :
- Business loans
- Purchases (car, furniture, etc.)
- Real estate loans
- Student loans
- Lending to friends and family
Example of Loan Note
Let us look at an example to understand the concept. Recently, David approached a retail investor to lend him $200,000. Unfortunately, the investor is not a close acquaintance of David, so they don’t share a relationship of trust. However, the investor agreed to pay him the money subject to a loan note, safeguarding him against David’s inability to repay.
The loan note included the amount of the loan, interest rate charged, loan tenure, schedule of repayment, associated fines or penalties, and the course of action if David fails to repay the principal and interest on time. It also clearly outlined the loan disbursal schedule and repayment timeline. It is a legally binding agreement, so both parties must honor the document’s terms and conditions.
Advantages of Loan Note
The following are some of the major advantages:
- It enables the lender to act, claim, and recover the loan amount if the borrower fails to pay it back within the prefixed timeline.
- As it is legally enforceable, the lender can drag the borrower to court in the case of a default to safeguard its interest.
- It considers a secured lending instrument while dealing with a large amount of money, especially if the borrower and the lender won’t have a longstanding relationship.
- It secures the lender and helps claim the principal amount in case of bad debts.
- Start-ups or new entrepreneurs usually use it to access seed capital from friends and family.
- Individuals use it to avoid undue tax obligations due to a lump sum payment from a settlement or cash-out transaction.
- It is issued to borrowers with a good credit rating leading to a healthy credit risk profile.
Disadvantages of Loan Note
The following are some of the major disadvantages:
- First, it is usually a lengthy and legally binding document, making it very difficult for the involved parties to read. However, failure to read thoroughly can get them into deeper trouble.
- In some cases, it also includes early payment penalties that prevent the borrower from closing the loan account before its tenure.
- Although it provides legal recourse for both parties, the legal reviews are time-consuming.
Key Takeaways
Some of the key takeaways of the article are:
- It refers to the legally binding signed agreement between a borrower and a lender that outlines the commitments and obligations of both parties involved in the transaction.
- A typical loan note includes all the terms & conditions of the loan, such as the amount of the loan, repayment schedule, loan tenure, interest rate, and fees & penalties.
- This agreement is usually associated with business loans, purchasing cars or homes, student loans, or lending to friends and family.
- It enables the lender to act, claim, and recover the loan amount if the borrower fails to pay it back within the prefixed timeline.
- It is usually a very long document, making it very difficult to read and time-consuming. However, it is important to read the contract carefully as it is legally enforceable.
Conclusion
So, it can be seen that a loan note is usually issued when the loan amount is relatively on the higher side because it is considered a secured mode of lending. The legal contract safeguards the interest of the involved parties in the loan transaction, especially that of the lender. However, like any other financial instrument, it also has shortcomings that can be overcome to some extent through careful understanding of the terms and conditions of the note.
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