Promissory notes and bills of exchange are negotiable instruments that create debt obligations. Both create a legal relationship between two parties, requiring one to pay the other. While they serve similar broad purposes, there are important differences between the two types of instruments.
Find out when you should use them.
What Is a Promissory Note?
Most people are familiar with promissory notes because you must sign them when you take out a car loan, student loan, or mortgage. Promissory notes can also be used in business transactions or as a way to formalize a loan from a family member or friend. This type of instrument is essentially a formalized IOU, requiring one person to pay another by a set date. A promissory note is a written promise by the drawer (the borrower) to pay the payee (the person loaning the money).
A promissory note must include:
- The names and addresses of the drawer and payee
- The sum of money borrowed
- The collateral being used, if any
- The schedule of payments, if a payment schedule has been agreed to
- The specific date by which the full sum is due
- The amount of payments
- Signatures of both parties
The payee holds the note and returns it when the debt has been paid in full. If the drawer defaults on the note, the payee can enforce it in court.
What Is a Bill of Exchange?
Most people are unfamiliar with a bill of exchange since it is not commonly used in domestic business transactions and is never used for personal loans. A bill of exchange is similar to a promissory note, but has some key differences.
The first thing to know about a bill of exchange is that it is only used in international business transactions. It is governed by the United Nations Convention on International Bills of Exchange and International Promissory Notes.
A bill of exchange is an order to pay, not a promise to pay. The drawer directs its bank to pay the payee instead of paying the amount owed themselves. There is usually a sale of products that creates the relationship. The bill of exchange creates a period of time in which the payment will be made instead of a set due date.
There are three parties to a bill of exchange: the drawer (the person who owes the money), the payee (the person who will be paid) and the drawee (the bank who will pay the money).
Here's an example of a bill of exchange. Pretty Hats, Inc., located in Indiana, buys 200 fascinator hats from Fancy Frocks in London, England. The hats will be shipped in three months. Pretty Hats signs a bill of exchange which states that its bank, My Town Bank, is ordered to pay Fancy Frocks $2,000 within three months.
A bill of exchange must include:
- A statement that it is a bill of exchange
- The names and addresses of the drawer, drawee, and payee
- The amount to be paid
- Where the payment is to be sent
- The period in which the payment is to be made
- A directive that the drawee is to pay the payee
- The signature of the drawer and date it is signed
A bill of exchange is transferable (much in the same way you can endorse a check to someone else). Bills of exchange are enforceable in court in the event of nonpayment.
Bills of exchange and promissory notes both create an obligation to pay, however they have different uses and terms.