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What is a promissory note and how it works
Learn the promissory note definition, how it works and what are its pros and cons.
Promissory notes are versatile financial tools used in a variety of scenarios, from personal loans and business financing to real estate transactions and debt consolidation. They serve as binding agreements that outline repayment terms, providing clarity and security for both lenders and borrowers. Their straightforward format and enforceability make them especially useful for documenting private loans, structuring payment plans, or formalizing financial commitments in a professional setting.
What is a promissory note?
A promissory note is a written promise from one person or business to pay another. Also known as loan agreements or IOUs, these documents lay out the terms and conditions of a loan and ensure that the agreement is legally enforceable. Promissory notes are commonly used for loans from alternative lenders, such as individuals or private companies, rather than traditional financial institutions like banks or credit unions.
For example, these can be used for business loans, student loans, car loans, and personal loans between friends and family members. You should use these written agreements when you lend or borrow large sums because they ensure that both borrowers and lenders understand the details of the loan and the consequences of non-payment. When the terms of the agreement are comprehensive and the document contains all the necessary signatures, promissory notes are considered legal documents that protect both parties.
What to include in a promissory note
A promissory note should clearly outline all the details of a loan and its repayment terms. Along with the names of the borrower and lender, it may also include:
- Amount of money borrowed (principal amount)
- Amount to be repaid (principal and interest)
- When and how often payments will be made (payment schedule, or “due dates”)
- Interest rate and repayment specifics
- Time frame and maturity date (date the loan will be fully repaid)
- Consequences for late payment (late fees) and/or for failure to pay the full amount
- Identification and description of collateral or property securing the loan
- Statement of any rights of the lender to transfer or assign the note to someone else
- Date and place of issuance
- Signature of both lender (payee) and borrower (payer)
How does a promissory note work?
Promissory notes strike a balance between the simplicity of an IOU and the formality of a loan contract. While an IOU simply acknowledges a debt and the amount owed, a promissory note goes further by including a commitment to pay either on demand or at a specified future date, along with details such as the repayment schedule and terms.
A concise promissory note might look something like this.
Interest and repayment of a promissory note
Promissory notes can follow various repayment structures, though most involve repaying the principal along with interest. The interest rate may be fixed or variable and can be calculated on a daily, monthly, annual, or other basis. In some states, interest rates are regulated by law and may have caps. Consulting a certified accountant and an attorney can provide valuable guidance on the tax and legal implications of the promissory note’s repayment terms.
- Installment promissory note - this is a common repayment method that involves the borrower making regular payments, with the repayment schedule and interest terms varying based on the agreement.
- Simple note - this is often used for smaller loans, an approach that requires the borrower to repay the entire amount in a lump sum on a specified date as outlined in the promissory note.
- Open-ended promissory note - this allows the borrower to draw funds from an operating or other loan over time and repay the borrowed amount plus interest by an agreed-upon date.
- Demand note - this is a type of arrangement where repayment is required "on demand," meaning the lender can request full repayment at any time.
Types of promissory notes
As mentioned above, promissory notes are commonly used for student loans, mortgages, or personal loans from friends or family members. They are also occasionally issued to corporate clients for business transactions. This means that the most frequent types of notes are:
- Student loan promissory notes - Many individuals sign their first promissory notes when obtaining student loans. Private lenders usually require a new promissory note for each loan, while federal student loan borrowers can often use a single master promissory note (MPN), allowing access to multiple loans over up to 10 years if eligibility is maintained.
The promissory note outlines the borrower's rights, responsibilities, and loan terms. By signing an MPN, the student agrees to repay the loan, including interest and fees, to the U.S. Department of Education. The MPN also collects the student's personal and employment details, along with references' contact information.
- Mortgage notes - a signed mortgage promissory note is the actual promise to repay the loan, along with the terms of repayment.
Typically, the promissory note includes the loan amount, interest rate, potential changes to the rate (for Adjustable Rate Mortgages), payment due dates, repayment duration, payment address, and consequences for missed payments. It outlines the debt amount, interest rate, and late fees, and the lender holds the promissory note until the loan is fully repaid. Unlike the mortgage or deed of trust, the promissory note is not recorded in county land records.
- Corporate promissory notes - promissory notes are frequently used in business for short-term financing. For instance, a company facing cash flow issues may issue a promissory note to creditors, promising repayment once it collects its outstanding receivables. Alternatively, a company may seek immediate cash from a bank in exchange for a note. Corporate promissory notes tend to carry higher default risk than bonds, and therefore offer higher interest rates to attract investors. These notes must be registered with the state and the Securities and Exchange Commission (SEC). If they are not registered, investors must assess the company's ability to repay the debt. In some cases, distressed companies may use high-commission brokers to sell unregistered notes, and if the company defaults, investors may have limited legal options.
Frequently asked questions about promissory notes.
Where can I find a template for a promissory note?
Many personal finance and legal reference sites offer promissory note templates in a variety of formats. If you don’t find one template that fits the bill, you can always make a template of your own in Adobe Acrobat. Whatever template you use, be sure to save it somewhere so you can use it again. Remember that it’s always a good idea to have documents of this type checked by a lawyer before using them, whether you’re using your own template or one you found online.
Are promissory notes safe for lenders?
Answer: Check the borrower’s credit first. Lower credit scores indicate greater risk and merit higher interest rates. Always get security, or collateral, which is property the borrower agrees to forfeit to the lender if they can’t repay the loan amount (often referred to as a “secured promissory note”). Unsecured promissory notes are riskier investments because they can lead to your having to hire a collection agency or file a costly lawsuit if the borrower defaults.
When you determine the interest rate, be sure the rate you set complies with state law. It never hurts to get legal advice to minimize risk before you decide to make the loan.
Are promissory notes safe for borrowers?
Answer: If you are the borrower, protect yourself from exorbitant rates and check your state’s usury laws. Also, check to see if you must pay interest on late payments. This can increase your cost of borrowing if you don’t keep your payments current. If the note is for business purposes, make sure that the borrower is the business, not you personally. You don’t want to have to pay the debt yourself if the business can’t pay. Generally, it’s a good idea to consult a lawyer before borrowing money.
Can I use promissory notes for personal loans?
Yes. You should use written agreements like promissory notes when you lend or borrow money from family or friends to ensure that everyone understands the details of the loan and the consequences of nonpayment. A promissory note for a personal loan ensures that the loan is seen as a business transaction that’s separate from your personal relationship.
Is a promise to pay agreement the same as a promissory note?
Yes. A promise to pay agreement is a promissory note. They both include loan details, repayment schedules, and borrower/lender information.
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What is a promissory note and how to write one.
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