Copyright ©  2009  Regents of the University of Minnesota. All rights reserved.

It is common for farm operators to enter into numerous financial agreements— the leasing of land or equipment; borrowing money from a bank or other lender to acquire land, livestock, machinery or equipment; purchasing land on a contract for deed; or cosigning or guaranteeing another's commitments. Each of these financial arrangements involves a contract of some kind.

Contract Elements
For an agreement between two parties to be legally enforceable, four requirements must be met:

1. The parties must be identifiable and competent.
2. The subject matter of the agreement must be legal.
3. There must be a mutual agreement.
4. There must be consideration given.

Unless both parties to a contract are known, there is no method of determining who is obligated to meet the terms of the contract. In addition, a party to a contract must be of legal age and may not be suffering from a mental disability.

The subject matter of a contract must be legal. For example, the law imposes limitations on interest amounts that can be charged on certain types of loans. Therefore a loan agreement with an interest rate that exceeds the legal maximum is not a legal contract. Although the parties to a contract must mutually agree to the terms of the contract, the agreement need not be in writing to be enforceable. Mutual agreement requires only an offer and an acceptance of the offer. Consideration may consist of money, goods, or services, or merely the promise of future consideration. Essentially, consideration is something given in exchange for something else.

Although contracts need not be in writing to be legally enforceable, there are a few important exceptions. To be legally enforceable, the following contracts must be in writing:

1. Contracts that cannot be completed within one year;
2. Contracts for transfers of interests in real estate;
3. Contracts to sell goods valued at $500 or more;
4. Credit agreements; and
5. Loan guaranties.

In general, it is a good idea to have all contracts in writing, even if not legally required. Having them in writing helps avoid confusion in the event of a dispute.

The previously outlined principles of contract law form the basis for the various contracts that a farm operator may enter into during the course of operating a farm. Several types of contracts are discussed here.

Promissory Notes
A promissory note—the borrower's written promise to repay a loan—is a legal contract used in nearly every transaction in which a farmer borrows money. A typical promissory note also includes the terms and conditions of the loan. In some cases, such terms may be complex and lengthy. When that is true, a loan agreement may be used to further explain the terms and conditions of the loan.

Promissory notes must state the loan amount and the interest rate, which may be either fixed or variable. In recent years, variable, or floating, interest rates have become increasingly popular. Even when the interest rate is fixed, however, a promissory note may provide that if the borrower fails to make the payment specified by the loan agreement, a different interest rate may be charged. A note also may provide that additional late payment charges are triggered in the event of a late payment.

The promissory note should clearly set forth the repayment schedule. It should specify the amount of each payment, and when and where it is to be made. Borrowers must be sure they understand these terms completely, since even a minor deviation may constitute a default. Borrowers should be particularly aware of promissory note clauses that address the lender's rights upon default. Such clauses can have drastic consequences for a defaulting borrower.

Most promissory notes contain a provision obligating the borrower to pay, in addition to all principal and interest provided in the note, all costs of collection in the event legal action must be taken by the lender to collect the balance due under the note. A typical clause reads:

The borrower shall pay all costs of collection of this promissory note, including, but not limited to, attorneys' fees, paid or incurred by the lender on account of such collection, whether or not suit is filed and whether or not such costs are paid or incurred, or to be paid or incurred, prior to or after the entry of a judgment.

In addition to late fee and legal reimbursement provisions, most promissory notes contain an acceleration clause providing that the lender can demand full payment of the loan if the borrower fails to make a required payment. A typical acceleration clause reads:

If any required payment under this note is not paid when due, or if an event of default occurs, accrued interest thereon shall, at the option of the lender, be immediately due and payable, without notice of demand.

Promissory notes also should state whether the borrower may prepay all or any part of the loan. Some lenders do not allow prepayments or, if prepayment is allowed, may impose a fee.

Finally, the promissory note should specify whether the loan is secured or unsecured. If the loan is unsecured, the lender has no priority over other creditors should the borrower default. If the loan is secured, the lender has prior claim to the property owned by the borrower that has been pledged to the lender as collateral. For a more detailed discussion of the legal aspects of such grants of security, see two other fact sheets in this series: Mortgages and Contracts for Deed and Security Interests in Personal Property.

Types of Notes
Depending on the loan situation, several types of promissory notes can be used. A simple note is unique in that repayment is in one lump sum at the end of the note. No periodic payments of interest or principal are contemplated with a simple note. As a result, such notes generally are used for a relatively short period of time.

A demand note provides that a lender may demand repayment at any time. A demand note is therefore very risky for the borrower since the lender may call for payment without advance notice or prior scheduling.

An installment note provides for periodic payments of principal and interest that will reduce the loan balance to zero by the end of the period specified in the note. In some cases, installment notes call for a balloon payment prior to the date at which the full amount of the loan would have been paid off if payments had continued. Such a note combines features of an installment note and a simple note. The reduction of principal through periodic payments over a period of time is referred to as amortization of the loan.

An open ended, or revolving, note is used when a line of credit is arranged by the parties. Under such an agreement, the borrower establishes a line of credit with the lender in the amount set forth in a promissory note. The borrower may obtain draws, or advances, up to, in the aggregate, the maximum amount specified in the promissory note. The borrower may make additional withdrawals against this line of credit once a portion of the amount previously borrowed or advanced has been repaid. The advanced and unpaid principal balance of the promissory note may not exceed the maximum amount specified in the promissory note, however. Open ended notes allow the borrower more freedom in the use of borrowed funds. Farmers often use such revolving loans for operating funds for a production cycle.

Third Party Agreements
A lender may require that someone besides the borrower—a third party—sign the promissory note. Such a requirement may be imposed when a borrower has little additional property to be used by the lender as means of repayment. The third party or cosigner of the note is liable for the loan and can be sued for payment if the borrower defaults. The cosigner remains responsible for repaying the loan as long as the borrower and lender operate under the original agreement.

As an alternative to cosigning the note, a third party may guarantee payment of the loan, agreeing to pay the lender if the borrower does not. Occasionally, a lender may require a guarantor or cosigner to pledge separately owned property as collateral. Using one's own property as collateral for the debts of another should be carefully considered. The cosigner or guarantor should be fully aware of all the facts and circumstances surrounding the loan before entering such an agreement.

Regulation of Promissory Notes
Many states, including Minnesota, have enacted laws limiting the rate of interest a lender can charge. Legal maximum interest rates cannot be avoided even when both parties to a contract agree to a higher rate. The maximum rate of interest that can be charged in Minnesota depends on the purpose for which the loan is made, the identity of the parties, and the loan amount.

The Federal Truth in Lending Act imposes detailed reporting requirements on lenders thereby providing borrowers with meaningful disclosure of credit terms and protecting consumers against inaccurate and unfair credit billing practices. Agricultural transactions, however, are fully excluded from the act.

To order other publications in this series, contact the University of Minnesota Extension Store, 20 Coffey Hall, 1420 Eckles Avenue, St. Paul, MN 55108-6069, e-mail: order@extension.umn.edu or credit card orders at 800-876-8636 or (612) 624-4900 (local calls).

• Agricultural Production Contracts (WW-7302).
• Bankruptcy: Chapter 7 Liquidations (WW-7295).
• Bankruptcy: Chapter 11 Reorganizations (WW-7296).
• Bankruptcy: Chapter 12 Reorganizations (WW-7301).
• Bankruptcy: The Last Resort (WW-2598).
• Contracts, Notes and Guaranties (WW-2590).
• Farm Leases (WW-2593).
• Financing the Farm Operation (WW-2589).
• Mortgages and Contracts for Deed (WW-7293).
• Mortgage Foreclosures (WW-7297).
• Rights of Unsecured Creditors (WW-7299).
• Tax Considerations in Liquidations and Reorganizations (WW-7300).
• Termination of Contracts for Deed (WW-7294).
• Termination of Security Interests in Personal Property (WW-7298).

The fifteen publications are also available as a package: Farm Legal Series (WW-7291).

This publication is designed to provide accurate information in regard to the subject matter covered. It is published with the understanding that the authors and the University of Minnesota are not engaged in rendering legal, accounting or other professional services. If legal advice or other professional assistance is required, the services of a competent professional should be sought.

Produced by Communication and Educational Technology Services, University of Minnesota Extension.

In accordance with the Americans with Disabilities Act, this material is available in alternative formats upon request. Please contact your University of Minnesota Extension office or the Distribution Center at (800) 876-8636.

University of Minnesota Extension is committed to the policy that all persons shall have equal access to its programs, facilities, and employment without regard to race, color, creed, religion, national origin, sex, age, marital status, disability, public assistance status, veteran status, or sexual orientation.