A negotiable instrument is a written document where someone unconditionally promises to pay an agreed-on amount of money to another person or organization. This document may specify the payment date or allow for an on-demand payment.
Here’s how negotiable instruments work, the different types that exist, and when you may need one.
Definition and Examples of a Negotiable Instrument
A negotiable instrument is a piece of paper that is like a contract in that it specifies the agreement between the payer who signs it and the payee who is promised the money. The document must specify the amount of money and may include a certain date by which the money must be paid or else be available on demand.
The agreement must also be unconditional. This means that there’s no other promise or order involved besides the payment of the funds. The instrument is “negotiable” in that the person holding it can choose to transfer it to someone else through endorsement.
You’ll find negotiable instruments classified as either drafts or notes. You’d use a draft to order someone to be paid a certain amount of cash. On the other hand, a note would be used to promise the payment of money, such as through a loan.
For example, a personal check you write to pay a bill collector would be a draft since you’d write out the check to order your bank to pay the bill collector the money owed. On the other hand, a promissory note you sign to take out a federal student loan would be a note since the document promises to repay the government for the money borrowed for your education.
For either type of negotiable instrument—a draft or a note—there’s a promise or order involved, but this doesn’t necessarily guarantee the money involved will be paid as agreed. If the promise is not met, legal action could be taken.
How a Negotiable Instrument Works
Negotiable instruments exist as an alternative to cash in instances where someone wants to promise or order the payment of a specific amount of money. Individuals commonly use negotiable instruments like checks and money orders for everyday transactions where they need to order someone to be paid money. Both businesses and individuals may use negotiable instruments like promissory notes for financing purchases through loans. Borrowers would agree to pay back the money through the stated financing plan along with any other costs, such as interest.
A valid negotiable instrument must meet the requirements set by the Uniform Commercial Code (UCC). The person making the agreement must create a written document, sign it, include a clear promise or order, and not require any conditions for the payment. The document must state the amount of money to be paid as well as other details such as any interest, exchange-rate considerations, or extra fees involved. The agreement must be for money, and payable to the specific payee at either a specified time or through immediate presentation of the instrument.
To be “negotiable,” the holder must also have the right to transfer the instrument to another party if they desire. Various types of endorsements exist for this purpose. For example, you could use a special endorsement to transfer an instrument to another named party. You might use a restrictive endorsement to specify a term—like only allowing for a deposit—or you might use a conditional endorsement to allow for the payment only under a certain condition, such as when the payee turns a certain age.
For example, let’s say you write out a personal check to your cousin for $100. You would write the check out to the order of your cousin’s name, provide the payment amount of $100, and put the date to show when you approved the payment. You’d then sign on the signature line to officially order the payment to your cousin. When you provide the check to your cousin, they can endorse the back of the check and cash it on demand to receive their money from your bank. They can also deposit it into their account. There are no extra conditions they need to meet to get their money. As the payee, your cousin might also sign the check over to someone else to allow for transferability.
Types of Negotiable Instruments
Common types of negotiable instruments include certificates of deposit (CDs), cashier’s checks, traveler’s checks, promissory notes, bills of exchange, and money orders.
Certificates of Deposit
Considered a type of note, a certificate of deposit (CD) involves a financial institution agreeing to repay the amount of money an account holder deposits into a CD account. You would deposit money into a CD account for a period of time, such as six months or five years. In return, the financial institution would agree to pay you back that money plus interest that accrued when the CD matures.
Checks include various types of drafts such as personal, traveler’s, cashier’s, and certified checks. The check writer specifies the payee and amount of money, and the payee can endorse the back of the check to get their money on demand when they go to a financial institution.
The level of assurance with funding and common situations for use differ among these types of checks:
- Personal checks: You’d write a personal check from your checking or savings account. They don’t come with a guarantee that you actually have that amount of money in your account, which means if you have insufficient funds, the check would bounce.
- Certified checks: These are funded from your personal bank account, but the bank would verify you have the funds available and sign the check. Certified checks offer more security, but there’s still a chance your account may not have the funds when the payee tries to cash the check. You’d likely pay a fee for this official type of bank check that’s often used for major purchases.
- Cashier’s checks: Also usually requiring a fee and commonly used for major purchases, a cashier’s check offers higher security than personal and certified checks. That’s because the money would come from the bank’s funds rather than your account. How it works is you’d have the bank take the money out of your account first, then issue you the cashier’s check you can provide to the recipient.
- Traveler’s checks: These help reduce the risk of lost or stolen cash while traveling and often allow for a refund of your money if something happens with the check. You can buy traveler’s checks from financial institutions and may pay a small fee. You can cash, deposit, or exchange them at financial institutions where you travel.
Cashier’s checks or certified checks are often used for large payments, such as during the homebuying process when it’s time to make a down payment on a house.
Usually used for a loan, a promissory note will specify an agreement where a debtor will need to pay back a specific amount of money borrowed by a certain time, plus any interest. One or more people may be liable for the debt, and the promissory note may have a provision where the debt needs to be fully repaid on demand.
Bills of Exchange
A bill of exchange is a type of draft that may be used for domestic or international trade. A buyer will agree to pay a seller the specific money owed for goods by an agreed-on date. The parties usually use the help of a bank for this type of agreement.
Known as a check alternative, a money order specifies an amount to be paid to someone on demand. However, you provide the amount of money beforehand—usually plus a small fee—to a financial institution that will issue the money order. This type of negotiable instrument offers more security over a personal check since the money has already been provided, and you can use it without a bank account.
Do I Need a Negotiable Instrument?
While you may not necessarily need them, negotiable instruments come in handy, and you’ll likely use at least one of them in your everyday life. For example, you might use checks to pay your bills or give gifts without exchanging cash directly. If you take out a student or home loan to pay for these large expenses, then you’ll probably sign a promissory note as part of the borrowing process. You may also choose to put money in a CD to earn interest and grow your savings.
- A negotiable instrument is a written document either ordering or promising the payment of a specific amount of money either at a specific time point or on demand.
- Drafts and notes are the two categories of negotiable instruments used by individuals and businesses.
- This type of instrument must meet the Uniform Commercial Code’s criteria to be considered negotiable.
- The negotiable instrument’s bearer can choose to transfer it to another party such as by endorsing a check to be paid to the order of someone else.
- Some examples of negotiable instruments include checks, certificates of deposit, bills of exchange, promissory notes, and money orders.