A promissory note is a written agreement between a borrower and a lender to 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 option for borrowing or lending money.
Key Points
• Promissory notes are agreements that detail a loan’s repayment terms.
• Different types of promissory notes cater to various loan scenarios.
• Borrowers may repay the loan in a lump sum or in installments, or the money may be due on demand.
• Interest rates and collateral affect a promissory note’s level of risk.
• Notes are legally binding, requiring signatures and compliance with state laws.
What Is a Promissory Note?
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. If the borrower is a business, the issuer may wish to see its pro forma income statement when setting up a repayment schedule.
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.
Core Components
Promissory notes generally 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.
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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 specify the interest rate, repayment schedule, and whether the line of credit is secured or unsecured.
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. As with a conventional loan, however, the company will typically be expected to show the lender its balance sheet indicating that it is solvent.
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.
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 repay the loan, whereas the mortgage outlines the lender’s recourse for foreclosure in case the borrower cannot pay. Qualifying for a mortgage may also require a loan contract and more detailed financial information.
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.
Recommended: A Guide to What Mortgage Notes Are and What They Do
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, as 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.
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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.
Structured Repayment Strategies
Here are some effects of the various repayment plans to consider.
• Amortized payments: The borrower makes equal payments each month, paying down principal and interest together. The plus: The consistency makes it easy to plan and budget. The minus: The monthly installments may be costly.
• Equal monthly payments and a final balloon payment: Installments are likely smaller than with full amortization, because the borrower pays less toward principal; the balloon payment resolves that at the end. Upside: Lower monthly payments preserve more cash on hand for other needs. Downside: If the borrower plans to refinance the loan before the balloon’s due date, they run the risk that interest rates may go up.
• Interest-only payments and a final balloon payment: With monthly payments applied only to interest, the borrower owes the entire principal until the final balloon payment. Pro: This method allows for the lowest monthly payments. Con: The borrower pays more interest because they have possession of the full principal throughout the term of the loan.
• Single payment of principal and interest: This is the lump sum method, where everything is paid back on the specified date. For the most part, only friends and family members will accept this arrangement. Good news: Borrowers need not pay anything toward the loan each month (though escrowing money would be wise). Bad news: If the business cycle is in a contraction phase when the note comes due, repayment of a large sum all at once could be very tough.
Legal Implications of Repayment
Signing a promissory note makes the borrower legally liable for the loan according to the terms of the note. In many states, defaulting on a promissory note that’s part of a mortgage contract could allow the lender to foreclose on the house and then sue the borrower personally for any deficiency.
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.
Standard Template
Promissory notes must include language outlining an agreement and unconditional promise for the borrower to repay the loan. Additionally, the repayment must be 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.
Risks and Protections
Like any loan contract, a promissory note involves financial risk to both borrower and lender.
Unsecured promissory notes will likely entail a higher interest rate than secured ones. A higher interest rate makes paying off a loan more expensive, increasing the possibility of default.
Promissory notes secured with collateral tend to have lower rates, but borrowers who can’t pay the debt risk having their collateral seized.
Depending on due diligence, providing capital based on a promissory note may expose the lender to some financial risk if the borrower is untrustworthy. As noted, having collateral helps mitigate that risk.
As for protection, a promissory note safeguards the lender by recording the terms of the loan in a valid and enforceable contract. It protects the borrower by providing documentation of the loan in case of an audit.
Both parties should make sure the note follows state or federal laws governing loans or investments to ensure additional safety.
The Takeaway
Promissory notes create a binding promise to repay borrowed money. This financial agreement can be used when borrowing money from individuals, financial institutions, or both. To be valid, the note must contain all the important details about the principal, the loan term, the interest rate, and must be signed by both parties to the agreement.
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FAQ
What makes a promissory note legally binding?
A promissory note is legally binding if it includes the date of the loan, the dollar amount being borrowed, the signatures of both the lender and the borrower, the rate of interest, any collateral involved, the start date, and the repayment time frame. The note must also comply with any applicable state laws.
How is a promissory note different from a loan agreement?
A loan agreement is more comprehensive than a promissory note, with specific terms and defined rules and restrictions. Promissory notes usually suffice for loans from one person to another. If a business is involved or the loan amount is large, a loan agreement is more appropriate.
Can a promissory note be transferred?
Yes, it is possible to transfer ownership of the promissory note. If the borrower defaults, for example, the lender may sell or transfer the note to a debt collector. Or, if the lender needs to raise cash, they can negotiate with a buyer and sell the note.
What happens if someone defaults on a promissory note?
If a borrower defaults, the lender usually sends them a demand letter. If the borrower still does not pay, the lender can hire a collections lawyer to sue and get restitution through a court judgment. The lender may also have the right to seize any collateral and sell it at auction.
How long is a promissory note valid?
Depending on your state, the statute of limitations for promissory notes can range from three to 15 years.
Photo credit: iStock/fizkes
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