Promissory Note vs Bill of Exchange: Key Differences for Exams
A promissory note is a financial instrument that records a written and signed promise by one party to pay another a definite sum of money. It is commonly used in lending, borrowing, and various commercial transactions. The note includes essential terms such as the principal amount, repayment period, interest rate, payment schedule, and details of both involved parties. Its role sits between an informal "IOU" (which is not always legally binding) and a formal loan contract. Unlike verbal agreements, a promissory note offers more legal clarity and enforceability for both the lender and the borrower.
Key Features and Structure of a Promissory Note
A standard promissory note must include several specific elements to be recognized as a valid financial instrument:
- Written and signed by the issuer (borrower/maker).
- Names and addresses of both the borrower (issuer) and lender (payee).
- The exact amount borrowed.
- Maturity date, specifying when repayment is due.
- Interest rate and its calculation method (if applicable).
- Repayment schedule and penalties for overdue payment or default.
- Clauses related to prepayments, waivers, and amendments if relevant.
The lender or payee keeps the original note until repayment is completed. Once the full amount (plus any applicable interest) is paid, the lender cancels and returns the note to the issuer.
Practical Example and Format Illustration
For better understanding, here is a simple illustration of a promissory note:
| Sample Promissory Note Format | |
|---|---|
| Date: | [Enter Date] |
| Place: | [City, State] |
| For value received, I, [Borrower's Name], residing at [Borrower's Address], promise to pay [Lender's Name], residing at [Lender's Address], the sum of [Amount in words] ([Amount in numbers]), on [Maturity Date], with interest at [Interest Rate] per annum. | |
| Signature: | [Borrower's Signature] |
For instance, a startup company may draft a promissory note to raise a short-term loan. The note will state that the company promises to repay the borrowed amount, possibly when its accounts receivable are collected, including the specified interest.
Types of Promissory Notes
Promissory notes vary based on the repayment arrangement and use-case context. Common types include:
- Installment note: Repayment occurs through regular installments, which may include both principal and interest.
- Simple note: Used for smaller loans repaid as a lump sum by a specific date.
- Open-ended note: Lets the borrower access funds over a period and repay later (often used for lines of credit).
- Demand note: The lender can demand repayment at any time, as specified in the terms.
Promissory notes serve multiple sectors such as personal borrowing, student loans, real estate financing, and business credit arrangements.
Step-by-Step: Drafting and Analyzing a Promissory Note
- Identify and clearly state the names and addresses of the borrower and lender.
- Specify the loan amount and write the figure in both words and numbers.
- Clearly outline the interest rate (if any) and the method of calculating interest.
- Mention the repayment schedule: whether in installments or a single payment.
- Define the maturity date or the event triggering repayment (in case of demand notes).
- Include default and overdue payment provisions—interest, charges, or legal consequences.
- Sign and date the document; both parties should retain a signed copy for records.
Key Advantages and Risks
| Advantage | Risk |
|---|---|
| Useful for those who can’t obtain formal loans from banks | Can be riskier if the lender lacks strong legal recourse |
| More flexible terms compared to traditional loans | Legal complications may arise if the wording is ambiguous |
| Creates a legal record of the debt | Risk of loss or mishandling if the note is not properly managed |
Applying the Concept: Practice Question
Suppose Rohan borrows ₹20,000 from Ajay at 6% interest and agrees to repay in full after six months. Draft a simplified promissory note using the sample format above. Then, outline the steps Ajay should follow if Rohan fails to pay on the due date.
Key Takeaways
- A promissory note is a formal, written promise to repay a specific amount to another party.
- It must state all terms: parties, amount, repayment, interest, and maturity date.
- Different forms (installment, simple, demand) fit different borrowing needs.
- Clarity and precision are vital for enforceability and risk reduction.
For Further Learning and Practice
- Study related commerce topics such as Accounting Terms.
- Review additional concepts like Bill of Exchange.
- Explore practical exercises in Ledger and Journal Entries.
For deeper understanding, replicate different promissory note formats and practice analyzing sample notes. This will help you master both exam theory and real-world business transactions.
FAQs on Promissory Note Explained: Meaning, Format, Legality & Examples
1. What is a promissory note?
A promissory note is a written, unconditional promise by one party (the maker) to pay a certain sum of money to another party (the payee) or to their order, either on demand or at a specified future date. Promissory notes are legal documents governed by the Negotiable Instruments Act, 1881, and must be signed by the maker. They are widely used in commercial transactions for recording loans, advances, or settlements.
2. Is a promissory note legally binding?
Yes, a promissory note is legally binding when it meets all requirements under the Negotiable Instruments Act, 1881:
- It is in writing and signed by the maker
- Contains an unconditional promise to pay
- Specifies a certain sum of money
- Mentioned payee is identifiable
- Clear date and place of execution
3. What are the essential elements of a promissory note?
The essential elements of a valid promissory note are:
- Must be in writing
- Contains an unconditional promise to pay
- Signature of the maker
- Definite sum of money
- Payable to a certain person or to their order
- Date and place of issue (preferable)
- Stamp duty as per law
4. What is the difference between a promissory note and a bill of exchange?
The main differences are:
- Promissory Note: Is a promise to pay, involves two parties (maker and payee), and does not require acceptance.
- Bill of Exchange: Is an order to pay, involves three parties (drawer, drawee, payee), and needs acceptance by the drawee.
5. Can a promissory note be made payable to bearer?
No, in India a promissory note cannot be made payable to bearer on demand. As per the Reserve Bank of India Act, 1934, only the RBI or the Central Government can issue instruments payable to bearer on demand. Any such instrument issued by a private party is illegal and void.
6. Is an oral promise valid as a promissory note?
No, an oral promise is not valid. A promissory note must be in written form and signed by the maker to be legally enforceable as per Section 4 of the Negotiable Instruments Act, 1881.
7. What information should be included in a promissory note format?
A typical promissory note format includes:
- Date and place of execution
- Clear unconditional promise to pay
- Name of the payee or their order
- Specified amount
- Time of payment (on demand or fixed date)
- Rate of interest (if any)
- Signature, name, and address of the maker
- Stamp as per the law
8. Can interest be charged in a promissory note?
Yes, interest can be charged in a promissory note if mentioned. The rate of interest and manner of calculation should be clearly specified. If not mentioned, only the principal sum is legally claimable.
9. What happens if a promissory note is not stamped?
An unstamped or insufficiently stamped promissory note is not admissible as evidence in court. It is legally invalid for enforcement unless the appropriate stamp duty is paid as per the Indian Stamp Act, 1899.
10. Who are the parties involved in a promissory note?
There are two main parties:
- Maker: The person who makes and signs the note and promises to pay
- Payee: The person in whose favor the note is made (to whom payment is promised)
11. Give an example of a valid promissory note.
Example:
"Place: Delhi
Date: 10 April 2025
Three months after date, I promise to pay Mr. Amit or order the sum of ₹20,000 only, with interest at 7% per annum, for value received.
– (Signature of Maker)
Name: Ravi Sharma
Address: 123, South Avenue, Delhi"
12. What are the uses of a promissory note?
Promissory notes are used for:
- Documenting loans between individuals or entities
- Business credit arrangements
- Advances to suppliers or employees
- Student loans and tuition fee payments
- Recording private financial transactions securely
