Most people will borrow money at some point in life, and some will lend money. While an IOU might suffice for smaller amounts, a more binding agreement can be helpful when dealing with larger sums. With a promissory note, two parties formalize the lending of money.
Through this legal agreement, both the borrower and the lender consent to clearly defined repayment terms. Promissory notes can be used for a variety of purposes, including personal and commercial transactions.
Here’s a guide to common types of promissory notes, how to create one, and when they may be a good fit for borrowing or lending money.
Intro to Promissory Notes
Put simply, a promissory note is a written promise to pay someone a certain amount by a specified time. The type of promissory note and agreement between the issuer and payee dictate the payment schedule and amount.
Generally, promissory notes include the principal amount, interest rate, date and place of issuance, and signatures from the lender and borrower. There may also be provisions for late fees and recourse if a borrower defaults.
Similar to loans, promissory notes may be secured or unsecured. Unsecured notes are issued based on the borrower’s ability to repay, whereas secured notes use collateral such as real estate or a vehicle.
A promissory note may be issued by a financial institution, but this financing is commonly provided by individuals or businesses, too. Essentially, promissory notes allow anyone to act as a lender, which can be useful for creating legal documentation of a lending agreement between family members and friends.
Types of Promissory Notes
There are several types of promissory notes. Usually, the nature of the loan determines the appropriate type. Let’s take a closer look at some of the most common varieties.
Line of Credit Promissory Note
Borrowers can withdraw any portion of funds from a line of credit, up to the established maximum loan amount. Once the money is taken out, the borrower is liable for repaying the lender.
A promissory note can be used to guarantee that the borrower repays money withdrawn from the line of credit. The promissory note can determine the interest rate, repayment schedule, and if the line of credit is secured or unsecured.
According to the 2020 Small Business Credit Survey from Federal Reserve Banks, business lines of credit and home equity lines of credit had approval rates of 79% and 69% , respectively. While a promissory note may be used by these traditional lenders, they are an option for creating a line of credit from other sources.
Investment Promissory Note
Businesses looking to access capital can sell promissory notes to investors instead of taking out a conventional business loan or a line of credit.
Through an investment promissory note, businesses receive capital from investors in exchange for fixed repayments. In the event a business is unable to repay, the investors may acquire the company.
Generally, investment promissory notes are sold at a discount to account for the impact of inflation on future payments. Promissory notes may be sold publicly in some cases but are most often purchased by corporate entities and experienced investors with high net worth who can handle the greater level of risk.
Businesses must be licensed to sell investment promissory notes, which must be registered with the Securities and Exchange Commission. Investors can verify promissory notes at the SEC’s EDGAR database .
Real Estate Promissory Note
Promissory notes can be used in mortgages and other real estate purchases. In practice, borrowers use a home or other property as collateral for a real estate promissory note.
While promissory notes can accompany a mortgage, they are in fact different. The note provides legal documentation of the borrower’s promise to pay, whereas the mortgage outlines the lender’s recourse for foreclosure if the borrower cannot repay the loan. A mortgage may also require a loan contract and more detailed financial information to qualify.
Real estate promissory notes can be used outside a mortgage. For example, two individuals could create such an agreement. Although the lender may not have the power of foreclosure, they can secure the agreement with the authority to place a lien on the property if a borrower defaults. A property lien creates a public record of a borrower’s unpaid debt.
Keep in mind that real estate promissory notes can be traded through brokerages without the borrower’s consent.
Student Loan Promissory Note
College students will likely be required to sign a promissory note for both private and federal student loans.
For private lenders, each student loan may carry its own promissory note since terms can vary. Anyone taking out federal student loans must sign a Master Promissory Note to promise repayment of loans, fees, and interest to the U.S. Department of Education. The MPN can cover multiple loans within a 10-year time frame for authorized schools.
Recommended: Understanding Your Student Loan Promissory Note
Vehicle Promissory Note
A vehicle promissory note creates a binding document that promises a borrower will pay a lender for a car or other type of vehicle. This agreement can be between two individuals or a borrower and a conventional lender, such as a bank.
Aside from repayment terms and conditions, it’s important to include the vehicle’s make, model, year, body, and VIN in a promissory note.
Personal Loan Promissory Note
It’s not uncommon to sign a promissory note when acquiring a personal loan from a traditional lender.
A promissory note can also be used for a personal loan between friends and family. Formalizing the loan amount and repayment terms through a promissory note can help avoid disagreement and protect both parties down the line. Compared with typical personal loan requirements, a promissory note can be a more flexible financing option.
Having financial information like credit score and proof of income at the ready can streamline getting approved for a personal loan.
Promissory Note Repayment Options
Besides type, promissory notes can differ by repayment method. Borrowers can expect to repay money and interest through one of the following options:
• Lump sum: This requires the entire amount to be repaid in a one-time payment on a specific date. Lump-sum payments are more common with small loans.
• Due on demand: The borrower must repay the loan upon the lender’s request. Due on demand payment is used frequently for promissory notes between friends and family members. Any promissory note without written payment terms is considered due on demand.
• Installment: Installment payments follow a specified schedule (monthly, for instance) to pay back a loan over a longer period of time. Usually payments are structured as equal amounts and include interest.
• With (or without) interest: A promissory note can define the interest rate and any related contingencies.
In some cases, a promissory note may employ a combination of repayment options. For example, a vehicle promissory note may include an upfront lump sum followed by installment payments.
What Does a Promissory Note Look Like?
There are different laws in every state regarding promissory notes. One common feature of promissory notes is that they must be written. A verbal agreement between two parties will not qualify as a promissory note or carry the same legal enforceability.
Promissory notes must also include language outlining an agreement and unconditional promise for the borrower to repay the loan. Additionally, the repayment must constitute money, rather than labor, professional services, or other capital.
Other details and elements generally needed in a promissory note include the following:
• Amount or principal: How much was borrowed and is to be repaid
• Payor: The party promising to repay the debt
• Payee: The party lending the money
• Interest rate: States how much interest is charged and how it is calculated
• Start date: The date the promissory note becomes effective and funding is released to the payor
• Maturity date: When the interest and principal must be repaid in full
Without these elements, lenders may have trouble enforcing the promissory note.
Promissory notes create a binding promise to repay borrowed money. This financial agreement can be used when borrowing money from individuals and financial institutions.
If you’re weighing options, consider a personal loan with SoFi.
SoFi offers no-fee fixed-rate personal loans of $5,000 to $100,000, and the application can be completed entirely online.
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