Note Payable: Key Terms, How They Work

During the course of business, it's inevitable that you'll come across a note payable at some stage or another. When you do you must understand what it is, how it works, and what its requirements are.

To enable you to do this, this post will look at notes payable in more detail and show you what they are, what information they should contain, and how you should account for them.

What is a Note Payable?

A note payable, or promissory note , is a written agreement where a borrower obtains a specified amount of money from a lender and promises to pay it back over a specific period. In simple terms, a note payable is a loan between you and a lender. The lender can be an individual, a financial institution, or even a company.

In terms of the agreement, the interest rate may be fixed where you'll pay the same interest rate on the amount outstanding over the life of the loan. It could also be variable where the interest on the loan changes based on certain factors, such as a benchmark interest rate.

Typically, a note payable contains the following information:

• The amount to be paid in terms of the note.
• The interest rate applicable to the loan.
• The maturity date.
• Name of the maker or payer of the loan.
• Name of the payee.
• The signature of the person who issued the note with the date signed.

Understanding Note Payables

Examples of when you may need to use a note payable when:

• You buy materials in bulk from a supplier or manufacturer.
• You buy a building or equipment for your business.
• You loan a substantial amount of money from a bank or other financial institution.

Keep in mind, though, that these are just examples of where notes payable may be used and there are many more, depending on the type of business you have.

Also, notes payable can be classified as short-term or long-term liabilities. As such, when the note payable is due within 12 months from the date of signature, it's classified as a short-term liability. Furthermore, it is classified as a current liability on the company’s financial statements because it is paid within the company’s operating period. In contrast, if it's payable at a later date, it's classified as a long-term liability. Long-term liability is generally used to determine a company’s solvency.

Irrespective of whether it's a long-term or short-term liability, at any time when a note payable is issued, your bookkeeper or accountant should classify it as notes payable. In contrast, if you are owed an amount in terms of a promissory note, your account should classify it as a note receivable.

Here is an article about note payables in more detail.

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Example of a Note Payable

With that in mind, let's look at an example of a note payable. Let's say Steve borrows $60,000 from Bob on 1 February 2021. Steve signs the note payable and agrees to pay Bob $60,000 two years later, or by the latest 31 January 2023. In addition, Steve also agrees to pay all Bob a 20% interest rate per year, payable every two months.

In Steve's balance sheet the note payable will be classified under long-term liabilities because the amount is due after 12 months. Remember, if the amount was due within 12 months, it would be a short-term liability and would be classified under current liabilities in the balance sheet.

In Steve's journal, the amount he receives in terms of the note payable, $60,000, will be debited to his cash account and will be credited to the notes payable account.

In addition, the interest on the note payable will need to be recorded every time interest is paid. To do this, Steve will set up an interest payable account under his current liabilities because the interest is paid short-term.

Here, Steve will credit the interest payable account with the amount of interest due, which, in this case, amounts to $2,000. He will also debit the interest expense account with the same amount.

When the interest is paid, Steve will debit the interest payable account and credit his cash account with $2,000. Keep in mind that every time interest is paid in terms of the note payable, Steve will need to make this entry.

Key Terms in a Note Payable

For a note payable to be a valid and enforceable legal agreement, it must include the following key terms:

• The loan amount.
• The repayment dates.
• The interest rate.
• Default terms.
• The names of both the lender and the borrower.
• The mailing address where each payment is mailed to.

Besides these terms, the lender may also require certain restrictive terms as part of the agreement. These can include, for instance, terms that prevent the paying of dividends to investors while any part of the loan is still outstanding.

Often, if these terms are breached, the lender then has a right to call up the loan, although it is possible for the lender to waive these breaches and continue to accept monthly or periodic payments from the borrower. Also, a note payable may require collateral as security for the loan.

It's also important to keep in mind that, for a note payable to be valid and enforceable, the borrower should print, sign, and date the note payable.

Image via Pexels by Andrea

Notes Payable vs. Accounts Payable

Although accounts payable and notes payable are both liabilities and represent amounts payable to businesses or financial institutions, there are some significant differences between the two.

Accounts payable are always short-term liabilities because they are due and payable within one year. These accounts payable involve credit received from businesses and vendors which require no written agreements and usually, no interest is charged on them. Accounts payable are typically day-to-day business expenses that businesses incur including supplies, utilities, goods, or professional services.

As said above, notes payable are written agreements that involve interest and can be classified as long-term or short-term liabilities.

Get Help With A Note Payable

Because notes payable often involve substantial amounts of money with interest, they must contain accurate and relevant information.

Fortunately, many financial services lawyers can help you when it comes to notes payable and give you the advice you need. If you need any more information on notes payable or advice regarding them, feel free to visit our website where you’ll find many other resources.