What Is a Promise to Pay Agreement?

What Is a Promise to Pay Agreement?
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While a promise to pay agreement is exactly what it sounds like – a promise to pay or repay money – it is much more than that. It is a contract between two parties that outlines the terms of the agreement and provides legal protection if a borrower promises to pay back the full amount of the loan and tries to renege on repayment. Such an agreement, which states out the loan terms, is known as a "promissory note," or IOU.

Types of Promissory Notes

Promise to pay agreements come into play with any type of loan. In real estate, a mortgage contract, for example, is a common form of a promise to pay agreement.

According to the U.S. Securities and Exchange Commission, because it has a collateral attached, it is considered a secured promissory note. The loan agreement stipulates that the lender can seize and sell the home if the borrower doesn't pay the remaining loan amount according to the agreement's terms, such as when they continuously make late payments and eventually default.

A private, unsecured loan agreement between two people, such as family members or friends, typically requires a promise to pay even if there is no set repayment date beyond the agreement to pay the specified amount when the borrower can. The SEC says it is considered an unsecured promissory note. Apart from personal loans, other types of promissory notes that are unsecured include commercial papers.

Additional Applications of Promise to Pay Agreements

Promise to pay agreements are not just for loans. Other agreements include promises to pay for services rendered and promises to pay for performance. For example, if you sign an employment contract, your employer is promising to pay you a predetermined amount for each hour, month or year of labor you provide.

Generally, courts look at other types of agreements to be as binding as loan agreements. The Supreme Court of New York ruled in 2012 that an employer must honor an oral promise to pay an employee a performance bonus, notes Justia.

Is an Oral Promise to Repay a Loan Binding?

Oral agreements are difficult though not impossible to prove in court if the payer defaults. In theory, you can loan or borrow money on a handshake, but what happens if someone doesn't pay what they promised? How are you going to prove the terms of the agreement in court?

Typically, the party receiving the money per the agreement should only rely on an oral promise to pay agreement if they can afford to take a loss on the amount owed. That is why a written agreement is the way forward.

The promissory note or loan agreement should include the principal amount, interest rate and the due date or repayment schedule. You can always include the penalty in the event of default after the maturity date has passed. You can find various free promissory note templates online to see what these documents typically include.

A written promise to pay agreement or IOU will not prevent a payer from not honoring the agreement. However, it will provide proof of the terms should the payee have to sue the borrower to get the amount of money owed.

Caution When Dealing With Promissory Notes

According to the Office of the Comptroller of the Currency, the federal government regulates promise to pay loan agreements under the Truth in Lending Act. Lenders must provide borrowers with a statement that explains how much the loan costs; when a lender or loan issuer can assess charges, such as late fees, beyond the standard accrued interest; and what rights the borrower has.

Usually, states govern the amount of interest that lenders charge through usury laws that prevent lenders from charging exorbitant rates on loans. If you are unsure about your state laws, you are better off consulting a law firm and paying the attorney’s fees before signing any binding legal document. Alternatively, you can download your state promissory note template and use it to create a binding loan contract or agreement, complete with a payment plan.

Also, if you are the lender, you must report the interest as taxable income when you file your state and federal income taxes.