An unsecured promissory note with a balloon payment can be a great way to obtain financing for your business. The note doesn't require collateral, and the balloon payment gives your business time to grow before having to make a substantial repayment.
Unsecured Promissory Note Basics
An unsecured promissory note is a loan that is made without collateral. Collateral is when property is placed against the loan for security—for example, when you take out a mortgage, the house is the collateral. If the loan is defaulted on, the lender gets to take possession of the property.
An unsecured note is commonly used to get funding to run a business from family or friends when your business has no credit rating, so other loans are not available. The lender gives you the money and you promise to pay it back. Your promise is the only thing securing this unsecured note; there is no physical collateral. The promissory note is the legal document that describes the terms of the loan.
Understanding Balloon Payments
When you take out a loan, you usually have to make regular payments to the lender throughout the life of the loan. Often the payments are made up of principal and interest (which is amortized over the life of the loan), so that when you get to the end of the loan term, the last payment will pay off the final balance and the loan will be paid in full.
A balloon payment works a bit differently. A loan with a balloon payment is structured so that the borrower makes smaller, regular payments throughout the life of the loan, and the final payment that is due is much larger than the regular payments.
Loans with balloon payments are generally structured that way to give the borrower time to make a business profitable. The regular installment payments are low, so that the borrower can keep money in the business and focus on making it successful. Sometimes the regular payments are interest-only, or they may combine interest with some principal. The balloon payment at the end comprises all or most of the principal of the loan.
Making a Balloon Payment
When you take out a loan with a balloon payment, it's important to plan for that payment as part of your business plan. It can be easy to push thoughts of it aside, since it is far off in the future, but the truth is that it can sneak up on you and you need to be prepared.
Begin planning for the balloon payment at least one year in advance. Refinancing can be one way to manage a balloon payment, but you must be sure the refinancing closes in time.
Documenting a Balloon Payment
Your balloon payment should be the final payment on the loan. Once you have made the payment, the lender should provide a final payment release or debt release letter that indicates you have fully satisfied the loan, including the balloon payment, and it is now paid in full.
Creating the Unsecured Promissory Note
The lender can write a promissory note themselves if they are comfortable with what it should contain and have researched state laws. They also could consult with a local attorney to create the letter or work with an online service provider.
An unsecured promissory note with a balloon payment can be an advantageous way to structure financing for a business. The key is planning for and being prepared to make the balloon payment at the end of the loan.