Consider this example of an IOU in its most basic form. Let’s say you borrow $1,000 from your friend. To prove the existence of this debt agreement, you write “I will pay you back $1,000 on January 10, 2022” on paper and give it to that family friend. That handwritten note serves as an IOU—albeit, a very informal one since it does not outline any other repayment terms.
How Does an IOU Work?
An IOU typically isn’t held to a high standard concerning the repayment terms of the debt when compared to other types of loans. Technically, an IOU can simply show that a debt exists and not include any details about the due date, interest rate, or payment installments. Although an IOU note can document a promise to repay a loan, its informal nature makes it unclear whether an IOU is a legally binding contract in some cases. A promissory note should outline additional repayment terms, such as:
Contact information for both parties (legal names, addresses, and phone numbers)Loan amountWhen the debt must be repaidWhether the debt is paid in installments or all at once by the due dateInterest rateThe total amount owed (principal plus interest)Default termsSignatures and date signed
In a court of law, the judge uses these terms to determine whether the debt was of value to both parties. If the lender were to benefit from this arrangement—earning interest, for instance—it would help distinguish the IOU as a contractual arrangement, rather than simply a gift. Let’s expand on our earlier example. A promissory note might read: “The undersigned John Smith promises to pay to the order of Jane Doe the sum of $1,000 with interest from November 01, 2021, on the unpaid principal at a rate of 5%. The unpaid principal and accrued interest will be paid in full on November 01, 2022.” The borrower, John Smith, and the lender, Jane Doe, would each sign the note to signify an agreement on the loan terms.
Formal IOUs
In some cases, IOUs are terms used for formal financial instruments. One example is IOUs in the bond market. Unlike their informal IOU counterparts, bonds are formal debt arrangements that companies and governments issue to raise money. When an investor purchases a bond, the bond issuer is expected to repay the loan with interest after a specific length of time, sometimes making periodic payments.
IOU vs. Promissory Notes
Some may fear that creating such a transactional agreement with a family member or friend could strain the personal relationship. However, setting clear expectations for both parties is often prudent when money is involved. Not only do clear expectations protect the lender’s interests, but they can give the borrower a moment to seriously reflect on whether they can take on the terms of the note. Failing to repay a loan can sometimes do more damage to a relationship than clarifying the contract.
