An IOU (I Owe You) is a document that records the existence of a debt. It is usually considered an informal agreement and less likely to be legally binding than a formal contract.
Definition and Examples of an IOU
An IOU is an informal document – sometimes handwritten – that records the existence of a debt. Since it typically is not a formal written contract, it may not be legally binding to the same degree as other loan agreements, such as a traditional mortgage.
Suppose you borrowed $1,000 from your friend. To prove the existence of this debt agreement, you write “I will pay you $1,000 on January 10, 2022” on a piece of paper and give it to your friend. This handwritten note is considered an IOU – although it is quite informal as it does not specify any other repayment terms.
How Does an IOU Work?
Typically, an IOU does not set forth high-level conditions regarding repayment of the debt compared to other types of loans. Technically, an IOU may simply indicate that a debt exists and not include any details about the due date, interest rate, or payment installments.
While an IOU 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.
When lending or borrowing money, it is often preferred to issue a promissory note rather than an IOU. A promissory note outlines the specific repayment terms, whereas an IOU is more informal and may not state specific repayment terms.
An IOU should specify additional repayment terms, such as:
- Contact information for both parties (legal names, addresses, and phone numbers)
- The loan amount
- When the debt is to be repaid
- Whether the debt is to be paid in installments or in a lump sum by the due date
- Interest rate
- Total amount due (principal plus interest)
- Terms of assumption
- Signatures and the date of signing
In a court of law, the judge uses these terms to determine whether the debt has value for both parties. If the lender stands to benefit from this agreement – for example, earning interest – this will help distinguish the IOU as a legal agreement rather than merely a gift.
Let’s expand on our previous example. An IOU might state:
“The undersigned, John Smith, promises to pay Jane Doe the sum of $1,000 with interest from November 1, 2021, on the principal due at the rate of 5%. The principal and interest due will be paid in full on November 1, 2022.”
Borrower John Smith and lender Jane Doe would sign the paper to indicate their agreement on the terms of the loan.
Formal IOU
In some cases, the term IOU is used for formal financial instruments. One example is an IOU in the bond market. Unlike their informal counterparts, bonds are formal debt agreements issued by corporations and governments to raise funds. When an investor buys a bond, they expect the bond issuer to repay the loan with interest after a specified period, sometimes occurring through periodic payments.
An IOU can also refer to registered bonds issued by the State of California in 2009. The state issued IOUs to cover a severe cash shortfall exceeding $3 billion in August 2009. This money went to fund obligations of the California public fund.
IOU vs. Promissory Note
IOU Promissory Note
- Only records the existence of a debt one party owes to another (or others)
- Records the existence of a debt and the terms of repayment (such as interest rate, due dates, and late fees)
- May
- Debt instruments contracts that lack repayment terms are not legally binding
- Debt securities are considered legally binding documents
- A debt security is generally not a transferable instrument that can be moved or traded
- Registered bonds with the U.S. Securities and Exchange Commission can be traded in the secondary market
What does this mean for you?
When using a debt instrument to lend a significant amount of money to a family member or friend, it is often beneficial to include your contact information and all repayment terms, including minimum payments, due dates, interest rates, and late fees. This effectively makes the debt instrument a promissory note. Both parties should sign the document.
Some may fear that creating such an agreement with a family member or friend may strain the personal relationship. However, setting clear expectations for both parties is often wise when it comes to money.
Clear expectations not only protect the lender’s interests but can also give the borrower a moment to seriously consider whether they can accept the terms of the note. Not repaying a debt can sometimes damage the relationship more than clarifying the contract does.
Source: https://www.thebalancemoney.com/what-is-an-iou-5202077
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