Promissory Notes

Whether you borrow money from a bank or someone you know, you should sign a promissory note -- a legally binding contract in which you promise to repay the money.

If you borrow start-up cash for your business from a commercial lender, the lender will require you to sign a promissory note that sets out the repayment terms. If you borrow the money from a friend or relative, it's still smart to sign a promissory note, even if the lending friend or relative assures you that such formality isn't necessary. 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 comes sniffing around with a business audit.

Types of Repayment Schedules

Banks provide their own promissory note forms. If you borrow from a friend or relative, you'll need to find a promissory note form. Their legal and practical terms can vary considerably, but the most important thing is to pick a repayment plan that's right for you. Here are four different approaches.

1. Equal Monthly Payments

This is the type of repayment schedule you’ve probably dealt with before. You must pay the same amount each month for a specified number of months. 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.

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 software such as Quicken or Microsoft Excel. Or you can use a printed amortization schedule. These are 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. Of course, when you're thinking about those nice low payments, don't forget the big balloon payment waiting around the corner.

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 soon 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

Here, you repay the lender by making regular payments of interest only. The principal stays the same. At the end of the loan term, you must make a balloon payment to repay this principal and any remaining interest.

The obvious 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

If your lender agrees, you can promise to pay off the loan all at once, at a specified 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. Unfortunately, you are unlikely to get this kind of deal from a commercial lender.

Read the Fine Print

No matter which repayment method you choose, be sure you 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. Make sure you can prepay the loan without paying any kind of 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. If the lender doesn’t agree, try to negotiate to owe a fee only if you prepay the loan within a very short time period.

Most commercial lenders will require you to pledge assets to secure repayment of the loan or possibly even require you to provide a cosigner or a guarantor.