What is Promissory Note? | Parties, Format, Pros vs Cons

A Promissory Note is one of the many credit instruments issued by a creditor to the debtor as a certificate of assurance that a particular payment will be made by a deferred date.

The Negotiable Instruments Act of India, 1881 defines a promissory note as a negotiable instrument that directs the payment of a specific amount of money to the creditor or the individual mentioned therein or the bearer of the instrument. The instrument comprises an unconditional written order that the maker must duly sign.

It must be noted that under the “Reserve Bank of India Act,” preparing a promissory note payable to the instrument’s bearer is illegal. That is why, from the above definition, the phrase “bearer of the instrument” must be ignored.

Besides that, the definition of a Promissory Note mentioned above may appear similar to that of a Bill of Exchange. However, in actuality, they are entirely different. It is because three parties are involved in a Bill of Exchange. In contrast to that, a Promissory Note involves two parties.

Key Takeaways

1. A promissory note is a legally binding document that outlines the terms and conditions of a loan agreement between two parties.
2. It includes details such as the loan amount, interest rate, repayment period, and consequences for defaulting.
3. A promissory note can be used in various situations, such as personal loans, business loans, and real estate transactions.

Parties in a Promissory Note

A promissory note primarily involves two parties:

1. Drawer or Maker: Also referred to as the promisor, it relates to a person who makes or issues the promissory note specifying the amount to be paid.
2. Payee or Drawee: Also referred to as the promisee, it is the person in whose name the promissory note is made or issued. The person is also the payee unless the note states any other person’s name as the payee.

Format of Promissory Note

A promissory note primarily comprises all the details of a deferred transaction or credit. These include the principal amount, interest rate (if any), place and date of issuance, maturity date, and drawer’s signature.

According to this promissory note specimen, David Johnson is the maker or the drawer who promises to pay a hundred thousand dollars to Mr John after three months from the date of issue, i.e., January 1, 2019. The term ‘value received’ implies that the statement has been generated due to some loan or purchase.

If the drawer, David Johnson, endorses this statement obliging another individual, say, Mr Green, the latter will become the payee. Similarly, if David Johnson discounts the note from a bank, the bank will serve as the payee.

Advantages of Promissory Note

A Promissory Note has several advantages, which is why it is considered one of the most convenient credit instruments. Here are some significant benefits provided by a promissory note.

1. A Promissory note’s format is straightforward, making its issuance incredibly hassle-free.
2. It can be used for private as well as trading purposes.
3. It does not involve many formalities. Consequently, the transfer of money takes relatively less time.
4. It incorporates the financial needs of both the drawer and the drawee. The former can pay on a deferred date, while the latter can get an immediate price by discounting the instrument from a bank.
5. It does not affect the debt-to-equity ratio of a company.

Disadvantages of Promissory Note

Despite its varied advantages, a promissory note has some significant limitations. These include:

1. It can be used for only short-term services. It cannot be used as a source of investment for big ventures.
2. It is a risky credit instrument for new borrowers as the short and simple sentences in the note may hide some unfavourable terms. Consequently, the borrower may have to pay a massive sum for the liabilities incurred.

References

1. https://heinonline.org/hol-cgi-bin/get_pdf.cgi?handle=hein.journals/mnlr14&section=29
2. https://books.google.com/books?hl=en&lr=&id=8UBDndXgNIYC&oi=fnd&pg=PA7&dq=Promissory+Note&ots=5U0Vr52-ki&sig=DlmvqjOew-tn1y1DaprRcuUwE88