Pros and Cons of an Interest-Only Secured Promissory Note

Pros and Cons of an Interest-Only Secured Promissory Note

by Brette Sember, Esq., November 2018

An interest-only secured promissory note is a loan that is secured with property and requires interest-only payments through the life of the loan, with a large balloon payment for the principal at the end of the loan term. This type of loan has benefits and drawbacks to consider.

How This Type of Promissory Note Works

A promissory note is a loan, with one person borrowing money from another and promising to pay it back. A secured promissory note is a loan that has collateral. A piece of property is placed against the loan as security. An auto loan is a type of secured loan. So is a mortgage. For a loan like this for your business, you might place a piece of business equipment against the note to secure it. If the loan is not repaid, then the lender can seize the collateral.

With most loans, you take out the loan and then the principal and interest are divided up into equal payments throughout the life of the loan. When you make the last payment, the loan is paid off. When the loan is interest-only, you only pay interest throughout the life of the loan. The final payment on the loan is called a balloon payment and equals the entire principal. This amount is due at the end of the loan period.

Pros of an Interest-Only Secured Promissory Note

There are benefits of this type of loan to take into account when deciding if it is the right source of funding for you:

  • The loan payments (up until the last payment) are smaller, allowing you to keep money in your business.
  • Using collateral to secure the loan often means you can get a better interest rate than with an unsecured loan.
  • Making the loan payments on time will help build credit for your business and may give you the ability to refinance the loan before you get to the balloon payment at the end.

Cons of an Interest-Only Secured Promissory Note

There are drawbacks to this type of loan that you must consider when choosing your financing:

  • The loan is secured with collateral, so, if you don't make the payments, the lender could seize the collateral.
  • It can be difficult to come up with the funds to pay a large balloon payment at the end of the loan without careful planning.
  • You may have plans to refinance the loan before you get to the balloon payment, but if your business is not doing well or its credit rating has been hurt, you may not be able to refinance in time.
  • Because you do not build equity in the loan (as you are only slowly building up how much of the collateral you pay off), the loan can be challenging to refinance.

Creating This Type of Note

The lender can draw up a promissory note themselves if they wish, but it is best to work with an attorney or an online service provider to help ensure that the note is legally binding and meets all of your state requirements.

Interest-only secured promissory notes can be a convenient way to obtain financing for your business. However, it is important to weigh the pros and cons of this type of loan before making a decision.