Do you plan to get personal loans to finance your farm operation?

Farmers often take out personal loans from friends or family members to help them finance their farm operation, whether to purchase farmland, buy equipment, or to fund general operating costs. This is can be a good option. Unlike institutional banks, family or friends will typically not make you jump through a lot of hoops to “qualify” for a loan or pay hefty loan initiation fees. However, farmers should still take the arrangements seriously. No matter how informal the arrangement or friendly the lender, farmers should have a promissory note in place for every loan they take out.

What are promissory notes?

A promissory note is the document necessary to formalize a loan arrangement. Basically, it is a straightforward written contract between the lender and the borrower that sets out the terms of the loan arrangement–particularly when and how the money will be paid back–and explains the rights and obligations of each party if things don’t go as planned. Promissory notes are relatively simple documents. It’s well worth the time and effort to have one in place whenever a loan is obtained to support a farm operation.

What is the difference between a loan agreement and a promissory note?

Historically, loans included both a loan agreement and a promissory note, but recently the two have been merged into a single document. This is basically because people realized that having two separate documents caused needless paperwork. The loan agreement used to include all the details about installment payments and both the lender and the borrower had to sign it, while the promissory note was a much shorter document where the borrower promised to pay the full amount and only the borrower had to sign it. Today the two names–loan agreement and promissory note–are used almost interchangeably, but the promissory note is the standard lending contract used between family and friends.

What are the benefits of the promissory note?

Having all of the agreed-to terms in writing provides evidence of the loan arrangement. This has several benefits. First and foremost, this serves to solidify the terms and get the parties on the same page. No one wants money to sour friendships or family relationships, but unfortunately it happens all the time. Formalizing the agreement and clarifying the terms for repayment can help prevent misunderstandings and disputes. And, if disputes do arise, the parties can simply go back to the agreement and will most likely be able to resolve the issue without much fuss, while hopefully keeping their friendly or familial relationship intact.

In addition, having a promissory note in place can help prevent some key legal issues from coming up. It can alleviate certain tax issues for both parties; for example, it could help prevent the IRS from declaring the arrangement a gift and potentially charging the lender a hefty gift tax.

It can also help alleviate certain securities laws issues; for example, it could help prevent the SEC from coming in and saying that the borrower should have complied with certain securities laws and regulations.

What are the main components of the promissory note?

A promissory note answers five main questions about the loan arrangement.

The first three deal with the basics:

1. How much money is being loaned? This is what’s considered the “principal” amount of the loan, or basically how much money was received.
2. Who’s lending the money? This is legally known as the “Holder” of the promissory note–he holds the promise or IOU statement.
3. Who’s borrowing the money? This is legally known as the “Maker” of the promissory note–she’s the person that makes the promise or IOU statement. The borrower listed on the note could be the farmer personally. However, if the farm operation has formed a separate business entity, and the money is being used to support the farm operation, the borrowing party in the promissory note should be the entity itself. This is because to help maintain the integrity of the entity in the eyes of the law, the business entity’s financial matters–including debt from a loan–need to be kept separate and distinct from the personal financial affairs of the owner(s).The fourth and fifth deal with loan repayment:
4. How and when will the money be repaid? This part of the agreement will specify the timeline for when and how the money will be paid in full as well. Are payments due in installments, such as monthly, quarterly, or annually, or are they due all at once as a lump sum payment, say in two years? Are some or all of the payments made with in-kind products or services, such as produce or value added farm products? Will there be interest charges? If so, how much? As explained above, to protect the lender from being subject to a hefty gift tax, the promissory note should require interest charges at or above the latest minimum IRS-set interest rate.
5. What happens if the money is not repaid as agreed? This is an essential part of the promissory note, and is also likely the hardest to even think about let alone come up with a way to handle. While we can all hope that things will go as planned, we all know that issues and crises happen that may prevent a farmer from making a payment on time or completely following through with the terms of the loan. Setting clear guidelines and expectations for what happens in such scenarios can go a long way in helping maintain cordial and respectful relationships between family and friends if and when things go wrong.

The checklist and sample promissory note that follows provide more detail on each of these five components of a promissory note. If you are thinking that this seems quite straightforward, you are right! Typically, promissory notes are quite short and range between one or two pages. The sample promissory note we’ve included here may seem quite a bit longer, but that’s because it provides various alternatives and annotations to explain each provision.

Why is it important to create a customized promissory note?

One of the benefits of a promissory note is that it is quite flexible, so the provisions can be tailored to the precise needs and desired arrangement of the parties for the most part. While it may be tempting to just cut and paste the provisions included in the sample provided here or one found on the web, it’s best to think through your specific situation and create an agreement that’s best suited for you, your farm operation, and the friend or family member that is lending you money.

Finding friendly loans: the rise of peer-to-peer loans

If farmers plan to scale up their operations and need loans in amounts greater than their family and friends can provide, there are options from the public at large. Peer-to-peer loans are becoming quite popular these days. These are loans from strangers that can be accessed without going through a financial institution such as a bank. Peer-to-peer lending is also known as crowdlending or crowdfunding. If this is the route your farm seeks, be sure to use one of the many credible peer lending sites to facilitate the loan, as additional disclosure rules and security laws may apply. These sites should include all the necessary legal paperwork that you’ll need to be sure to have in place.