What Is a Negotiable Instrument?
A negotiable instrument is a signed document that promises a payment to a specified person or assignee. In other words, it is a formalized type of IOU: A transferable, signed document that promises to pay the bearer a sum of money at a future date or on-demand.
Common examples of negotiable instruments include personal checks, cashier's checks, money orders, certificates of deposit (CDs), promissory notes, and traveler's checks. The person receiving the payment, known as the payee, must be named or otherwise indicated on the instrument. Because they are transferable and assignable, some negotiable instruments may trade on a secondary market.
Key Takeaways
- A negotiable instrument is a signed document that promises a payment to a specified person or assignee.
- Negotiable instruments are transferable, which allows the recipient to take the funds as cash, then use them as they wish.
- Examples of negotiable instruments include checks, money orders, and promissory notes.
Understanding Negotiable Instruments
Negotiable instruments are transferable, so the holder can take the funds as cash or use them for a transaction or in another way as they wish. The fund amount listed on the document is the specific amount promised, and must be paid in full either on-demand or at a specified time.
A negotiable instrument can be transferred from one person to another. Once the instrument is transferred, the holder gains full legal title to the instrument.
These documents provide no other promise by the person or institution issuing them. In addition, no other instructions or conditions can be made for the bearer to receive the amount listed on the negotiable instrument.
For an instrument to be negotiable, it must be signed, with a mark or signature, by the maker of the negotiable instrument—the one issuing the draft. This entity or person is known as the "drawer of funds."
The term "negotiable" refers to the fact that the note in question can be transferred or assigned to another party; "non-negotiable" describes one that is firmly established and can't be adjusted or amended.
Examples of Negotiable Instruments
One of the more well-known negotiable instruments is the personal check. It serves as a draft, payable by the payer’s financial institution once it's received, in the exact amount specified. Similarly, a cashier’s check serves the same function but it requires the funds to be set aside for the person being paid before the check is issued.
Money orders are similar to checks but may or may not be issued by the paying party's financial institution. Often, cash must be received from the payer before the money order is issued. Once the money order is received by the recipient, it can be exchanged for cash.
Traveler’s checks function differently, as they require two signatures to complete a transaction. At the time of issue, the holder must sign the document to provide a specimen signature. Once the payer determines to whom the payment will be issued, a countersignature, or second signature, must be provided for payment.
Traveler's checks are generally used when someone is traveling to a foreign country and is looking for a payment method that provides an additional level of security against theft or fraud, although they are now largely outmoded in favor of credit cards as an alternative tohard currencyfor travelers.
Other common types of negotiable instruments include bills of exchange, promissory notes, drafts, and CDs.
What Is a Negotiable Instrument Used For?
A negotiable instrument promises a payment to a specified person or assignee. It is transferable, so it allows the holder to take the funds as cash, then use the money as they see fit.
What Is the Benefit of a Negotiable Instrument?
A negotiable instrument is easily transferable. There are no formalities and limited paperwork involved in making such a transfer. The instrument's ownership can be shifted simply by delivery or by a valid endorsem*nt.
What Are the Drawbacks to a Negotiable Instrument?
One drawback of negotiable instruments is the risk of loss or theft. If they are lost or stolen, there is a potential for financial loss. Also, they are subject to the risk of dishonoring, meaning that the party obligated to make the payment fails to do so. In addition, negotiable instruments rely on the verification of signatures to ensure their validity. But signature verification can be subject to fraud or forgery, creating a risk to the parties involved in the transaction.
What Are the Two Kinds of Negotiable Instruments?
There are two basic types of negotiable instruments: an order to pay (this covers drafts and checks) and a promise to pay (promissory notes and CDs).
The Bottom Line
A negotiable instrument, like as a personal or cashier's check, is a document that promises payment of an amount of money to a particular person or entity. It's characterized by being transferable: Ownership of the instrument can be handed over simply by delivery or by a valid endorsem*nt. The most common types of negotiable instruments are personal, cashier's, traveler's checks, money orders, promissory notes, and CDs.
