What Are Demand Notes?
A variety of loans are currently available for borrowers today. Depending upon your specific needs and your desired repayment terms, you will likely be able to locate a loan that closely matches your financial preferences. A demand note is an example of a unique loan format that accommodates a wide variety of situations and scenarios.
A demand note is commonly defined as a loan in which there is no fixed or explicitly stated repayment schedule or length of applicability. Although this type of flexibility may not be ideal for many business situations, demand notes are an excellent form of borrowing for more informal situations, such as those involving friends and family. In some situations, banks that have established a long track record of quality transactions with a borrower may also allow for a demand loan to occur. Understanding when and how these loans are deployed is valuable for all borrowers, regardless of their current needs.
A demand note is a form of loan that is commonly seen in the private sector but can also be utilized by banks with private customers. A demand note typically does not carry with it a payment schedule or fixed term, and the lender has the right to request the funds back at any point.
The Basics of Demand Notes
As mentioned previously, a demand note distinguishes itself from other loan formats due to the fact that there is no fixed repayment schedule or term associated with the borrowing. Because of this, a demand note may be able to accommodate scenarios which themselves have some degree of uncertainty or are currently lacking more concrete details.
As could be imagined based on the relatively amorphous terms of the loan, demand notes are typically small to medium in size and very rarely involve large sums of money. Additionally, individuals who are requesting and qualify for a demand note will typically be granted access to these funds without the need for any form of loan security. In other words, the borrower will not be required to put forward any specific form of collateral in order to gain access to the funds they need.
Lender's Perspective of Demand Notes
In exchange for the significant degree of flexibility provided to the borrower, the lender of the funds being exchanged as part of the demand note are also granted a measure of stability. Once the demand note is issued, the lender of the funds has the ability to request the principal of the loan back at any time as long as any agreed-upon advanced notification has been given. Typically, details such as these are agreed upon and input into the demand note contract which both parties sign prior to the initiation of borrowing.
As an example, consider the following. If a lender provides a borrower a $5,000 demand note, they may stipulate that they can request the funds back with a 14-day advanced noticed. In the event that the lender needs access to that $5,000 again unexpectedly, they can request it back from the borrower. However, they must give the borrower at least 14 days to prepare the return of the funds as per contract guidelines.
Exploring the Demand Note Contract
Yet another unique factor of a demand note is the specific type of contract that is used to initiate these transactions. Unlike more formal borrowing arrangements, such as mortgages, a demand note relies upon a more informal demand loan agreement. This document, although quite specific in its terms and stipulations, is not considered a legally enforceable document if the loan is taking place between two independent parties, such as friends or family members.
That being said, many experts consider the demand loan agreement to represent a form of moral arrangement between both parties. If a demand loan is issued by a bank to a customer, however, the loan agreement drawn up by the banking institution and agreed to by the borrower is, in fact, a valid legal document.
Demand Note and Interest Rates
Given the relatively loose requirements imposed by demand loans, particularly if these loans are used by family members, it is not uncommon for the subject of interest rates to be bypassed entirely. However, in a situation where a demand note is issued by a bank or other formal arrangement, these loans will be accompanied by some form of interest on borrowing.
According to Internal Revenue Service guidelines, any formal loan arrangement must be accompanied by, at the very least, the applicable federal rate of interest, or AFR. The AFR represent the minimum amount of interest that must accompany any formal demand note.
The IRS has established three tiers of AFR rates based on the length of borrowing, commonly referred to as short-term, mid-term and long-term. These rates are not arbitrary, but rather, are derived from various market parameters.
- Short-term AFR rates represent the current one-month average of yields from various market-based obligations, such as U.S. Treasury bills, that have short maturity lengths under three years.
- Mid-term AFR rates are based on the same obligations, although focusing specifically on maturity lengths between three and nine years.
- Long-term AFR rates are based on the identical obligations that have a maturity length of over nine years.
Exploring AFR and Income Tax
In the event that a demand note is issued without the AFR rate or higher attached to it, this may qualify the loan as eligible for taxation as income. For many reasons, this re-classification would be practical. After all, if a sum of money is loaned to an individual without any timeline for repayment or interest attached to the principal, there is virtually nothing to distinguish this from ordinary income.
As a general rule, the AFR rates for loans are updated on a monthly basis and published on the IRS website. Before issuing a demand note, lenders should consult this documentation in order to ensure that they are not exposing either themselves or the other party to unexpected tax obligations.
Demand Notes in the Corporate World
Although it has been mentioned that demand notes are often seen in private transactions between friends, family member and retail banking customers, it is also possible for corporations to utilize demand notes for their own objectives.
It is not uncommon for companies to issue demand notes to investors as a means of raising needed capital quickly. Although the specific terms attached to demand notes may change, corporations will often provide access to demand notes that feature a floating interest rate attached to them. It is interesting to note that many comparisons have been drawn between the issuance of demand notes by corporations and traditional money market accounts. That being said, demand notes have been proven to have a higher yield than money market accounts.
Demand Notes and Risk Tolerance
Given the fact that the issuer of a demand note has the right to call in their funds at any point with proper notification, some companies use a series of unique strategies in order to hedge the risk involved with demand note issuance. Diversification is key when choosing to use demand notes to raise capital. These notes will typically be sold to a variety of individual investors and other organizations in order to ensure that no single entity is holding too large of a stake. This tactic is commonly employed in order to help ensure that the likelihood of a majority of the notes being called in simultaneously remains relatively low.
Obtaining Demand Notes
In the event that a demand note is issued between private, non-corporate parties, the process of formalizing the note is as simple as authoring a demand loan agreement and having both parties agree to the terms involved. In the event that a company is choosing to issue demand notes as a form of financing, purchasing these particular loan instruments can be accomplished using a broker. Whatever your given method may be, it is essential that you take the time to review all available documentation and ensure that the loan is, in fact, what you had envisioned
In the event that you have questions about demand notes or the process involved in issuing/obtaining a demand note, you should consult with a financial advisor and/or investment advisor as soon as you are able. These individuals will help you review your own current financial status and determine whether or not investing in demand notes is conducive to you reaching your personal goals within your dedicated time frame.
Just because demand notes may represent an attractive investment for some individuals does not mean that these particular products are well-suited for all investors. As an investor, or as an individual seeking to borrow funds using a demand note, it is in your best interest to research this particular platform at length in order to ensure that all of your questions are answered fully prior to any money changing hands. Early preparation such as this will help increase the likelihood of a positive experience with this particular borrowing method.
A Word of Caution
As stated previously, the issuance of a demand note carries with it the assumption that the lender can request their funds back at any point in accordance with the early notification guidelines incorporated into the contract. With that in mind, individuals who borrow funds as part of a demand note and spend them immediately may discover that they are unable to pay back these funds if a situation arises where they are requested by the lender unexpectedly.
Unlike other forms of loans, which include a definitive and easily identifiable repayment schedule, demand notes are somewhat more unpredictable. Therefore it is essential that borrowers plan their finances with a high degree of detail and discipline in order to ensure that they will be able to satisfy the terms of their debt obligation at any point where it becomes necessary to do so.
It is this level of unpredictability that distinguishes demand notes from virtually all other borrowing platforms available today. While small amounts of money can cause less volatility during the borrowing process, borrowers should seriously consider their options before immediately jumping into a demand note, if only to ensure that they are truly capable of fulfilling the terms of their borrowing.
Ryan Cockerham is a nationally recognized author specializing in all things business and finance. His work has served the business, nonprofit and political community. Ryan's work has been featured on PocketSense, Zacks Investment Research, SFGate Home Guides, Bloomberg, HuffPost and more.