Demand notes

What Is Demand Notes?

A demand note is a type of short-term, non-interest-bearing debt instrument that is payable in full at any time upon the lender's request, or "on demand." Unlike other financial instruments with set maturity dates or fixed repayment schedules, a demand note provides the lender with immediate liquidity and flexibility, as the borrower is obligated to repay the principal amount whenever called upon. This characteristic places demand notes within the broader category of debt instruments, signifying a direct obligation from the borrower to the lender. They are distinct in their lack of a predetermined repayment timeline, making them suitable for situations requiring adaptable financing or informal lending arrangements.

History and Origin

The concept of demand notes has historical roots in periods requiring flexible financial mechanisms. Perhaps the most prominent historical example in the United States dates back to the American Civil War. In 1861, to help finance the Union's efforts, the U.S. Department of the Treasury was authorized by Congress to issue non-interest-bearing demand notes in denominations of $5, $10, and $20. These were the first paper currency issued by the U.S. government and were distinctive for their green ink on the reverse, earning them the nickname "greenbacks."¹⁸,¹⁷

Initially, these demand notes were payable "on demand" in gold coin at certain Treasury facilities, serving as a critical stopgap measure during the war until other funding arrived.¹⁶,¹⁵ While not initially legal tender for all private debts, they were accepted for public dues like taxes and customs duties, which further cemented their role in the economy. The success and circulation of these early demand notes laid some groundwork for the development of modern U.S. currency, including the Federal Reserve notes issued today.¹⁴,¹³

Key Takeaways

• Demand notes are debt instruments payable at the lender's request, lacking a fixed maturity date or repayment schedule.
• They provide lenders with high liquidity due to their "on demand" repayment feature.
• Historically, the term "demand note" is strongly associated with the first paper currency issued by the U.S. government during the Civil War.
• In private lending, demand notes can be informal yet legally binding agreements between parties.
• The terms of a demand note, including interest rates and notice periods for repayment, should be clearly documented.

Interpreting the Demand Note

Interpreting a demand note primarily revolves around understanding the conditions under which repayment can be triggered and any associated terms. Since there is no fixed maturity date, the lender holds the power to "call" the loan at any time. A well-drafted demand note should specify how a demand for repayment is to be made, often requiring a formal written notice from the lender. This notice typically provides the borrower with a reasonable timeframe to satisfy the obligation.

For borrowers, the absence of a set schedule means they must be prepared to repay the principal amount at short notice. This necessitates maintaining sufficient liquidity or having access to alternative funding sources. For lenders, demand notes offer significant flexibility, allowing them to retrieve their funds when needed, which can be advantageous in dynamic market conditions or personal financial planning. The terms, such as any applicable interest rates, also dictate the cost for the borrower and the return for the lender.

Hypothetical Example

Consider Jane, who needs to borrow funds quickly to cover an unexpected medical expense, and her friend, Mark, is willing to lend her $10,000. Instead of a traditional loan with a fixed repayment schedule, they agree on a demand note.

1. Agreement: Mark and Jane draft a simple demand note. It states that Jane owes Mark $10,000, and this principal amount is payable "on demand." They agree that Mark will provide 30 days' written notice before demanding repayment. They also agree on a nominal annual interest rate of 3%, payable monthly.
2. Execution: Jane signs the demand note, acknowledging her obligation.
3. Repayment: A few months later, Mark unexpectedly needs funds to make a down payment on a new home. He provides Jane with a written notice demanding the $10,000 repayment, giving her 30 days as per their agreement.
4. Outcome: Jane, having been aware of the "on demand" nature, has saved diligently and is able to repay the $10,000 plus any accrued interest within the specified 30-day period. This scenario highlights the flexibility for the lender and the need for preparedness by the borrower inherent in a demand note.

Practical Applications

Demand notes are found in various financial contexts, ranging from informal personal loans to specific corporate arrangements.

• Intra-Family Loans: Often used for loans between family members due to their flexible nature. A demand note can formalize the agreement while allowing for repayment without a strict schedule, only when circumstances necessitate.
• Bridge Financing: In business, demand notes can serve as a form of short-term bridge financing, providing immediate capital until more permanent financing, such as a long-term loan agreement, is secured.
• Bank Lending: Some banks may offer demand loans to trusted clients, typically businesses or individuals with strong credit, allowing them to draw funds as needed with repayment due upon demand.
• Government Treasury Notes (Historical): As seen with the U.S. Civil War "greenbacks," demand notes have historically been used by governments to raise funds, serving as a form of currency redeemable on demand.¹²

These applications emphasize the core characteristic of a demand note: the immediate redeemability at the lender's discretion, providing a versatile tool in financial planning.

Limitations and Criticisms

While demand notes offer flexibility, they also come with inherent limitations and potential criticisms, particularly concerning the borrower's perspective and certain tax implications.

For the borrower, the primary drawback of a demand note is the uncertainty of repayment timing. The lender can demand the entire principal amount at any moment, which can create significant financial strain if the borrower is not prepared to meet the obligation. This lack of a predictable repayment schedule makes financial planning more challenging for the borrower compared to a loan with a fixed maturity.

From a tax standpoint, especially concerning intra-family demand loans, the Internal Revenue Service (IRS) scrutinizes transactions that involve below-market interest rates. If a demand loan is made interest-free or at an interest rate below the Applicable Federal Rate (AFR), the IRS may deem the forgone interest as a taxable gift from the lender to the borrower.¹¹,¹⁰ This "imputed interest" can lead to unexpected income tax and gift tax liabilities for both parties, even if no interest was actually paid.⁹,⁸ To avoid these complications, it is generally advised that demand notes, particularly in informal settings, include an interest rate at least equal to the AFR.

Furthermore, legal enforceability can sometimes be a concern if the demand note is not properly documented or lacks clear terms. While typically enforceable under the Uniform Commercial Code (UCC) Article 3, ambiguities in the agreement could lead to disputes.⁷,⁶

Demand Notes vs. Promissory Note

Demand notes are a specific type of promissory note, which is a broader financial instrument. The key difference lies in the repayment terms.

All demand notes are promissory notes because they contain a promise to pay, but not all promissory notes are demand notes. A promissory note is a written promise by one party (the maker or borrower) to pay a definite sum of money to another party (the payee or lender) at a specified future date or on demand. Therefore, a demand note is simply a promissory note where the payment is explicitly "on demand," granting the lender the discretion to call the loan at their will.

FAQs

Can a demand note include interest?

Yes, a demand note can include an interest rate. This rate should be clearly stated within the terms of the note and must comply with applicable usury laws. Charging interest can also help avoid potential tax implications, such as the IRS treating forgone interest as a taxable gift.⁵,⁴

Is a demand note legally binding?

Yes, a properly executed demand note is a legally binding loan agreement, similar to other promissory notes. To ensure enforceability, it should clearly identify the borrower and lender, the principal amount, any interest rate, and how a demand for repayment will be made.³

What happens if the borrower cannot repay a demand note when demanded?

If a borrower cannot repay a demand note when requested, they are considered to be in default. This can lead to legal action by the lender to recover the debt. The consequences depend on the specific terms of the demand note, which may include provisions for late fees, acceleration clauses, or the ability for the lender to seize collateral if the loan was secured.²

Are demand notes commonly used today?

While not as prevalent in public circulation as they were historically, demand notes are still used in specific private lending scenarios, particularly for informal loans between individuals or for certain types of flexible financing arrangements in business.¹