1.) A promissory note is the official legal agreement parties enter to formalize a loan. Farmers should have a promissory note for every loan they get, including, or even especially, from family and friends. Promissory notes are relatively simple documents– basically, the promissory note must show the loan amount, when it will be paid, the rate of interest, and any collateral or security (such as a car or farmland) if applicable.

2.) The principal is the amount that is being borrowed and that needs to be paid back. It is also the amount that any interest charges will be based upon.

3.) This section is known as the promise to pay and lays out the amount owed and who the parties are. The maker of the loan is the borrower and the holder is the person who lends the money. Note that here the borrower is the farm operation entity, Mother Earth Farms LLC, and not Susie Earth herself. If the farm operation has formed a business entity, it’s best to have the loan be in the name of the entity in order to keep the business’ finances separate from its owners’ personal finances. However, even if the loan is in the business entity’s name, many lenders require that the individual owner(s) personally guarantee the loan. Here, Danny could require his sister Susie to personally guarantee the loan and if Mother Earth Farms LLC fails to pay the balance owed, Danny could seek the funds from Susie personally. A personal guarantee is particularly common for unsecured loans, which are loans where no collateral such as a car, land, or house, is pledged by the borrower.

4.) If the loan is between family members or friends, it may be tempting to charge less interest than a loan from a bank would. However, the IRS typically concludes that interest free or low interest loans from friends and family members are really gifts that may be subject to the gift tax. The best way to avoid this is to have a written promissory note and for the lender to charge at least the minimum IRS-set interest rate. The IRS posts rates on its website monthly. As of December 2015 the rate is 2.57%. For more about the gift tax read the section of this guide titled What’s the difference between a gift and a loan and why does it matter? Note that interest charges can rack up pretty quickly. In this sample scenario, which involves a loan for $20,000 for a three-year term at three-percent interest per year, Susie will end up paying $21,224.16. Overall interest charges will obviously be higher if the timeframe of the loan pay off is longer or if the interest rate is higher. Online interest rate calculators are available to help you determine what the actual charges will be over time.

5.) The parties can negotiate how and when the money will be paid back. We’ve included a few options here. The first is to make smaller regular payments–i.e. monthly, quarterly, annually, etc.–and then a larger payment at the end. This is a good option for a farmer who is starting a new farm operation or is purchasing new farmland. The catch is that the farmer will have to find a way to make the large lump sum payment at the end, which may present a challenge. How will you come up with the money if your farm operation is not profitable or you need to
spend your cash elsewhere? A more consistent payment plan, perhaps stretched out over a longer period, may be a better option. Solid financial planning, including preparing a monthly cash flow analysis, profit and loss statement, and an analysis of working capital (i.e. the capital used in your day to day operations, which is measured by current assets minus current liabilities) will help you determine how fast or slow to pay off a loan.

6.) The equal installment payment option provides a level of consistency, which many farmers may prefer. It’s like the phone or cable bill–you know what it is and you just pay it. This is a good option for farmers that have a consistent cash flow and prefer to spread out their payments equally over the course of the loan agreement.

7.) The lump sum option means that the borrower needs to make a single payment in full by a certain date. This option is useful for farmers who expect to roll into money at some point–whether it be, for example, in the fall after one-year’s harvest or at the end of year three when the farm operation has established some traction. The option to make no payments until that time enables them to really get their ducks in a row. However, if the farmer is not cautious to set enough aside, she could get herself into trouble.

8.) A payment in-kind loan is used when the borrower intends to pay back the holder in goods or services rather than cash. This sample agreement is written for our story of Mother Earth Farms LLC, which has a cattle and dairy operation. Of course, the dairy products and beef could be replaced with any product on your farm. You could also come up with another definition of market value–such as the going price at the local grocery store or even set a firm price such as $3 per pound of tomatoes. Note that the total amount owed includes the principal amount of the loan as well as the 3% annual interest. Yet another option would be to have a loan where part of the payment is made in-kind. For example, let’s say Danny more realistically wants $100 a month in cheese, milk, and beef. The remaining balance could be paid off according to one of the other three options–installments with lump sum, equal installments, or lump sum.

9.) This means that if Susie, on behalf of Mother Earth Farms LLC, gets the cash necessary to pay off the loan at some point earlier than December 2018, she can pay her brother back with no penalty and be done with the loan. This clause works with any of the payment options. Sometimes lenders like to charge a prepayment fee or penalty, or even outright prohibit prepayment. We discuss reason why in the checklist included in this guide. Be sure to review this part of the promissory note carefully, and be aware of any restrictions or fees for early payment.

10.) This means that for each payment made under the loan, the money will first pay off any interest charges that have accrued and then it will go to paying down the principal or amount of the actual loan. This is particularly relevant when there’s a high interest rate and the loan is for quite a long term. At first, a large chunk of the payment will go toward just the interest. Over time, the principal will gradually start to decrease.

11.) It may be unpleasant to think about the consequences of not paying the loan from friends and family on time, but planning for this possibility can help make it less stressful and awkward if and when it happens. Including a late payment charge such as the one included here provides the borrower, here Susie (on behalf of Mother Earth Farms), an added incentive to pay on time. It also saves the lender, here Danny, from the headache and frustration of not getting any upside if his sister Susie continues to pay late.

12.) An acceleration clause requires that the borrower pay off the loan immediately if certain conditions occur. It’s up to the parties to negotiate what conditions would trigger acceleration, or whether to even include an acceleration clause. Here, as this clause is written if Susie (on behalf of Mother Earth Farms) is over 30 days late on a payment, or if Mother Earth Farms LLC files for bankruptcy, Danny could choose to “accelerate” the loan. This means he could require the balance of the loan to be paid back in full immediately. Note that in the previous section, we give the borrower some flexibility in paying back the loan if the payment is made within 10 days of the normal due date. At this point a late fee of 5% is incurred on the amount owed. Now, if the payment is 30 days late, Danny could require Susie to pay the loan balance in full immediately. This is just one way of designing what happens if payments are late. Please consult the checklist section of this guide to learn more about other options.tied to the loan, it is known as a secured loan. ments are late for a number of days late. For example, if the payment is more Note that as this provision is written, the acceleration or requirement for immediate pay off does not happen automatically. It’s up to Danny to choose this result. If he does not, the promissory note would just continue as if nothing happened.

13.) A loan is either “secured” (collateral is attached) or “unsecured” (no collateral is attached). Collateral is anything of value that the borrower owns and pledges to make part of the debt to the lender if for whatever reason the borrower cannot afford to pay the money back. Examples of collateral include houses, land, cars, or anything else with a value equal or greater to the amount of the loan. If the lender requires collateral it’s called a “secured loan.” In effect, the lender gets what’s called a “security interest” in the property or item used as collateral until the loan is paid off. This means that if and when the borrower is in default on the loan, the lender could take the property or item pledged as collateral and sell it off to get the balance owed. Basically, secured loans are less risky for the lender as they offer the lender, here Danny, another layer of security to ensure that he will get his money back. If a promissory note is “unsecured” (no collateral is attached), then instead of taking the collateral, the lender must go through the normal debt collection process in court. Learn more about securing loans and how they may entangle you in securities laws in the section of this guide titled Is your promissory note a security, and why does it matter? This section will help you decide whether a secured or an unsecured loan is best in your situation. The following three provisions give examples of options for both secured and unsecured loans.

14.) In our example, Susie (on behalf of Mother Earth Farms LLC) is using the money loaned by Danny to purchase a 2-acre parcel of land adjacent to the farm that is worth $20,000–or the full amount of the loan. Let’s say that Danny requires that this farmland be attached as collateral. This would be pretty common and standard and it would function similar mortgage with a bank, yet without all the formality. Here, the collateral is specified in enough detail so the parties know what is being pledged–the land being purchased–and the description includes both the common address and legal description. So let’s say Mother Earth Farms LLC misses several payments and Danny activates the acceleration clause–or declares that the full balance must be paid immediately. If Mother Earth Farms LLC fails to make the payment in full, Danny could initiate the foreclosure process on the land to recover the unpaid amount. Other examples of collateral could include certain pieces of farm equipment, or even farm animals such as “six Ayrshire cattle.” Collateral for a loan can be any commodity or assets of your farm operation that has a discernable value. Make sure to specify how many and which items are collateral if you choose to list specific equipment or other assets your farm operation owns and be sure to provide enough level of detail so it’s absolutely clear what is being pledged as collateral. Note that when a loan is secured, the lender may want to take additional steps to secure his interest in the collateral. Learn more in the previous section, Checklist: Creating a Promissory Note.

15.) This option illustrates a very broad clause for a “secured loan” that puts all the business assets on the line as collateral for the loan. So if Susie (on behalf of Mother Earth Farms LLC) fails to make a payment, Danny could come after any and all of the assets of Mother Earth Farms LLC to recover the amount of the loan. If the parties choose this option, the lender would have to file a standard financing form–commonly referred to as the UCC-1–with the state agency managing UCC filings in the state where the business is located. This is a standard procedure in the world of commercial loans and is quite simple to do.

16.) This option means that there is no collateral for the loan. Watch out here, as having an unsecured loan with a business entity raises suspicion that this transaction falls within the definition of a “security” and is subject to federal and state securities laws. For more on that, see the following section–Is your promissory note a security, and why does it matter? One other point to consider is that if the borrower is a business entity, such as in this case, and the business has no assets or does not want to pledge any asset as collateral, the lender may require the business owner(s) to personally guarantee the loan. In our example here, Danny may require Susie, as the owner of Mother Earth Farms LLC, to personally guarantee the loan. Farmers should be wary to sign a personal guarantee–by doing so, Susie would be putting all of her personal assets on the line, such as her car, house, and even future wages.

17.) This is a standard term that says that Mother Earth Farms LLC will be responsible for additional fees Danny incurs if he has to go out of his way to collect late payments.

18.) This is a standard clause that specifies that if any disputes arise, they will be governed by the state that the parties choose. In this case Mother Earth Farms LLC is located in the fictional State of Sun and the parties have agreed that the laws of Sun will be the applicable law.