Pros and cons of using an unsecured promissory note

Whether you are the borrower on an unsecured promissory note, or the holder of the note, there are potential advantages and disadvantages.

Types of unsecured promissory notes

Promissory notes can be classified in two ways: by the length of the loan, and by the manner in which the loan is repaid. Loans may be considered long-term or short-term. Although there is no legal definition, a short-term loan is generally for a year or less.

Promissory notes are typically repaid in one of three ways:

• Installment payments. Payments are made on a regular basis, most often monthly. Each payment consists of principal and interest, calculated so that the loan is paid in full with the last payment. This payment plan is most often used with long-term loans.
• Lump sum payment. There are no installment payments of either principal or interest, and the full amount is due on a date specified in the note. A variation of this is a promissory note payable on demand, which means that there is no specific date set and the loan must be paid in full at any time the noteholder requests it. Lump sum payments are more common with short-term unsecured promissory notes, although they are sometimes used with long-term loans as well.
• Balloon payment. This is a combination of the installment and lump sum payment. Periodic payments are made, which may include principal and interest, or only interest, leaving a large lump sum due at the end of the loan period. Balloon payments can be used with both short- and long-term loans.

If you are the borrower

If you borrow money and sign an unsecured promissory note to legally obligate yourself or your business for the debt, there are both advantages and disadvantages.

The advantages include:

• You may be able to use a promissory note to borrow money when you don't have a sufficient credit rating to obtain a commercial business loan from a bank or other lending institution.
• You can give a promissory note to provide some repayment assurance to friends or relatives who loan you money.
• You avoid pledging your property as collateral, as you would with a secured promissory note.

Some possible disadvantages are:

• You will likely pay a higher interest rate than for a secured loan.
• If you are using a promissory note because you don't have a good credit rating, you will likely pay a higher interest rate than if you obtained a commercial business loan from a bank or other institution.
• You could end up in default if you don't have funds available when an unsecured promissory note lump sum payment is due. Unless you can borrow money elsewhere to make the payment, or negotiate an unsecured promissory note modification with the noteholder, you will end up in court.

If you are the noteholder

You may be a promissory noteholder if you are the original lender, or if you bought the note. Being the holder of an unsecured promissory note also has its pros and cons.

Advantages of holding an unsecured note include:

• A promissory note may provide a higher interest rate, and therefore a greater return, than if you keep the money in your bank account.
• If you need money, you may be able to sell, or borrow against, the note.

Disadvantages include:

• An unsecured note will typically have greater risk than many other investments.
• If the borrower fails to pay, you will need to file a lawsuit to collect. Collecting on an unsecured promissory note is a two-step process. First, you need to obtain a judgment from the court. Then you need to try to enforce the judgment against the borrower's assets. However, if the borrower doesn't have sufficient assets that can be attached, your judgment may be worthless.
• Selling an unsecured promissory note is not as easy as selling a secured note. Unsecured promissory note buyers are more difficult to find, and will require a greater discount than with a secured note.

Unsecured promissory note forms

Promissory note forms are fairly simple. Click here to prepare an unsecured promissory note.