Loan Note
Definition
A loan note is a written promissory agreement that records the terms of a loan between a borrower and a lender. It sets out the principal amount, interest rate, repayment schedule, maturity date, and remedies for default. When used with real property, a loan note is often paired with a mortgage or deed of trust that secures the obligation.
How it works
- The loan note is a legally binding contract: both parties are obligated to the terms until the debt is repaid in full.
- Either party can draft the note, though lenders commonly prepare it.
- It specifies payment amounts, frequency (installments or lump sum), due dates, and what happens on default (late fees, acceleration, right to sue or arbitrate).
- Notes may be secured (collateral such as a home or vehicle) or unsecured.
What a loan note typically includes
- Names and contact information of borrower and lender
- Principal balance and interest rate (fixed or variable)
- Repayment schedule and maturity date
- Late-payment provisions and default remedies
- Prepayment terms and any prepayment penalties
- Signature of the parties (and sometimes notarization)
Note: Prepayment penalties protect the lender’s expected interest income but can increase cost for borrowers who pay off loans early.
Common uses and examples
- Mortgages: a loan note documents the borrower’s promise to repay a home loan; a mortgage or deed of trust secures the note against the property.
- Auto loans and other installment financing.
- Business loans and seed capital: informal or formal loan notes are often used by startups to obtain early funding from friends, family, or investors.
Benefits
- Provides a clear, enforceable record of the loan terms, stronger than an informal IOU.
- Can allow for staged repayments instead of a taxable lump-sum payment (useful in some settlements or cash-out arrangements).
- Simple to create and flexible for both parties.
- Can serve as a source of seed capital for entrepreneurs.
Legal and tax considerations
- A properly drafted loan note is usually enforceable unless the agreement was made under duress or fraud.
- Secured notes give lenders priority claim to specified collateral in case of default.
- Tax treatment varies depending on transaction type and jurisdiction; loan notes can sometimes defer taxable events compared with receiving cash.
- Parties should consider consulting legal and tax professionals before finalizing terms, especially on large or complex deals.
Key takeaways
- A loan note is a formal promissory document outlining loan terms and obligations.
- It is more legally robust than an informal IOU and is typically enforced unless invalidated by duress or fraud.
- Loan notes are used for mortgages, auto loans, installment financing, and early-stage business funding.
- Pay attention to prepayment penalties, security interests, and tax implications when negotiating or signing a loan note.