What Is an IOU?

IOUs Explained in Less Than 5 Minutes

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An “I owe you” (IOU) is a document that records the existence of a debt. It is typically considered an informal agreement and is less likely to be legally binding than a formal contract.

Since there are situations where an IOU is not legally enforceable, it’s important to understand how they work. Learn about the function of IOUs and tips for how to use them properly.

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 as legally binding as other loan agreements, such as a conventional residential mortgage.

Consider this example of an IOU in its most basic form. Let’s say you borrow $1,000 from your friend. To prove the existence of this debt agreement, you write “I will pay you back $1,000 on January 10, 2022” on paper and give it to that family friend. That handwritten note serves as an IOU—albeit, a very informal one since it does not outline any other repayment terms.

How Does an IOU Work?

An IOU typically isn’t held to a high standard concerning the repayment terms of the debt when compared to other types of loans. Technically, an IOU can simply show that a debt exists and not include any details about the due date, interest rate, or payment installments.

Although an IOU note 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 prudent to make a promissory note instead of an IOU. A promissory note outlines the specific repayment terms, whereas an IOU tends to be more informal and may or may not mention specific repayment terms.

A promissory note should outline additional repayment terms, such as:

  • Contact information for both parties (legal names, addresses, and phone numbers)
  • Loan amount
  • When the debt must be repaid
  • Whether the debt is paid in installments or all at once by the due date
  • Interest rate
  • The total amount owed (principal plus interest)
  • Default terms
  • Signatures and date signed

In a court of law, the judge uses these terms to determine whether the debt was of value to both parties. If the lender were to benefit from this arrangement—earning interest, for instance—it would help distinguish the IOU as a contractual arrangement, rather than simply a gift.

Let’s expand on our earlier example. A promissory note might read:

“The undersigned John Smith promises to pay to the order of Jane Doe the sum of $1,000 with interest from November 01, 2021, on the unpaid principal at a rate of 5%. The unpaid principal and accrued interest will be paid in full on November 01, 2022.”

The borrower, John Smith, and the lender, Jane Doe, would each sign the note to signify an agreement on the loan terms.

Formal IOUs

In some cases, IOUs are terms used for formal financial instruments. One example is IOUs in the bond market. Unlike their informal IOU counterparts, bonds are formal debt arrangements that companies and governments issue to raise money. When an investor purchases a bond, the bond issuer is expected to repay the loan with interest after a specific length of time, sometimes making periodic payments.

IOUs can also refer to registered warrants issued by the state of California in 2009. The state issued IOUs to cover extreme cash deficits of more than $3 billion in August 2009. These funds went to financing California’s general fund obligations.

IOU vs. Promissory Notes

IOU Promissory Note
Only records the existence of a debt one party owes to another party (or parties) Records the existence of a debt and its repayment terms (e.g., interest rate, due dates, late fees)
IOU contracts that lack repayment terms may not be legally binding Promissory notes are legally binding documents
Typically not a negotiable instrument that can be transferred or traded Notes registered with the U.S. Securities and Exchange Commission can be traded on a secondary market

What It Means for You

When using an IOU to loan a large amount of money to a family member or friend, it’s often useful to include your contact information and all repayment terms, including minimum payments, due dates, interest rates, and late fees. This essentially makes the IOU into a promissory note. Both parties should sign the note.

Some may fear that creating such a transactional agreement with a family member or friend could strain the personal relationship. However, setting clear expectations for both parties is often prudent when money is involved.

Not only do clear expectations protect the lender’s interests, but they can give the borrower a moment to seriously reflect on whether they can take on the terms of the note. Failing to repay a loan can sometimes do more damage to a relationship than clarifying the contract.

Key Takeaways

  • An IOU is an informal document that records the existence of a debt that one party owes to another.
  • Due to an IOU’s informal nature, it is unclear whether such a document would be legally binding in a court of law.
  • A promissory note is similar to an IOU except that it outlines the specific terms of repayment, such as the due date and interest rate.
  • IOUs can also be formal debt arrangements, such as bonds issued by private companies and the government.