What Is A Promissory Note And How Do They Work?
Sarah Li Cain8-minute read
November 01, 2021
You’ll most likely hear about a promissory note when you borrow money from a bank or other type of lender. This legal document outlines your promise to pay back the loan. It’s essentially an agreement between you and the lender.
Promissory Note: A Definition
A promissory note is a legally written agreement between a borrower and a lender. Though there are several types of promissory notes, generally this note will establish the relationship between the payor and payee, the total amount of money borrowed and the date by which the borrower should pay back the loan.
A promissory note is often included in a mortgage, student loan, car loan, business loan or personal loan agreement. Borrowers will typically sign the promissory note as one of the last steps to receiving their borrowed funds.
What Does A Promissory Note Do And How Does It Work?
Promissory notes legally bind the borrower and lender in an agreement where the borrower is responsible for paying back a loan or debt. They lay out the conditions of the loan and detail the time frame for paying back the loan as well as any interest that might accrue over the life of the loan.
While a promissory note, a loan agreement, and a mortgage are evidence of a debt owed from the borrower to the lender, the loan agreement has more extensive definitions and clauses than the promissory note. Only the borrower signs the promissory note, whereas both the lender and the borrower sign a loan agreement. The signed document means that the borrower agrees to pay back the loan.
When To Use A Promissory Note
A promissory note can be used for different types of loans such as a mortgage, student loan, car loan, business loan or personal loan. When lenders loan out money — especially when it’s a large sum — it formalizes the loan by creating a promissory note. This document is a legal record of your loan, helping to ensure the lender is repaid.
How Do You Write A Promissory Note?
The type of loan (secured or unsecured) will affect how the promissory note is written. That’s because a secured loan will outline the collateral the borrower has put up, and if and when the lender has the right to seize if the borrower doesn’t pay back the loan. An unsecured loan, on the other hand, can have a promissory note without any backing collateral. That means the lender will need to take you to court in order to enforce this type of promissory note.
In order for the promissory note to be valid, the borrower needs to sign it. The lender may require the borrower to sign this document in front of a notary to guarantee the signature. The original copy goes to the lender, and the borrower should get a copy.
What Is Included In A Promissory Note?
For a promissory note to be valid, it needs to include specific information.
- Names of the borrower and lender
- Amount of money borrowed
- Interest rate
- Type of collateral used (if applicable)
- Payment terms
- Payment due date(s)
- How to make payments
- Late payment penalties
Types Of Promissory Notes
While they are always legally enforceable, the different types of promissory notes have a few key differences. The type you’ll need depends on what’s being borrowed.
Informal Or Personal Promissory Note
Also known as personal promissory notes, these are typically between one friend or family member to another. This is a written guarantee that the money borrowed will be returned but does not always detail the purpose of the loan.
Commercial Promissory Note
A commercial promissory note is more formal and gives specific conditions of the loan. They’re used when borrowing money from a commercial lender such as a bank, credit union, or loan agency. They often require borrowers to repay the loan with interest, and the lender has a lien on the assets owned by the borrower until the payment is received.
For example, if you were to take out an auto loan from your bank, the bank would have a lien on your car until you repay the loan.
Real Estate Promissory Note
When writing a home loan or other real estate purchase, you would use a real estate promissory note. The home or real estate will be the collateral for this promissory note, and if the borrower defaults on their payments, the lender can place a lien on the property.
Investment Promissory Note
A company can issue a promissory note to raise capital. These promissory notes are unique because they can be sold to other investors. These can often be a substitute for a business loan.
Investment promissory notes reduce the risk of investing in a business by ensuring that the investors receive their return on investment over a specified period. If the borrower doesn’t pay back the money, the investor may legally take ownership of the company.
Car Promissory Note
A car promissory note is an agreement where a borrower promises to make payments in exchange for a vehicle. It typically has even terms throughout the loan, but often also includes a lump sum down payment at the beginning of the loan term. It also should include information about the make and model of the vehicle.
Student Promissory Note
You’ll typically see this type of promissory note for undergraduate and graduate loans, and they are unique because they often defer interest from accruing on your loans until after you graduate.
Additionally, the start date is often flexible and undetermined until you graduate. You might see a clause in a student promissory note that says that payments are not due until 6 months after leaving school, or other contingencies based on your education.
Promissory Note Repayment Plans
There are four main repayment plans, some of which may be combined. For example, a loan may have one lump-sum payment followed by installments. That, or the installments may be without interest for the first few months followed by interest payments for the remainder of the loan.
A lump sum payment means that the loan will be repaid (both principal and interest) all at once to the lender. Lump-sum payments are common with small loans. Lenders tell the borrower when the loan’s due, and the borrower will not have to make monthly payments.
Due On Demand
Also known as open-ended loans, due on demand means that the borrower must repay the loan when the lender asks for repayment. These agreements are more common for informal promissory notes and are typically between friends and family.
Borrowers will be allowed to pay back the loan when they can make the payments. If a promissory note does not have payment terms listed on the document, it will be considered due on demand.
Installment loans have a specified schedule of payments that allow a borrower to pay back a loan over time. This type of payment is common with auto loans and other expensive items. The installments, or payments, are typically made monthly and in equal amounts. The payments will include interest until the total loan is paid off.
A balloon payment is when a borrower will make equal payments for a predetermined amount of time and covers either the interest and principal, or interest only. The borrower will then need to make a final lump sum payment, paying off the remaining loan balance.
With Or Without Interest
The promissory note will specify the interest rate on the loan, or if there is no interest. If there are any contingencies with interest rates, they will be clearly defined in the promissory note.
Promissory Note Vs. Loan Agreement Vs. IOU
An IOU is the most informal type of agreement, and simply recognizes that a loan exists where the borrower owes the lender. A loan agreement, on the other hand, is the most formal type of document, and outlines both the lender and borrower’s responsibility in the loan.
A promissory note combines elements of both, where there is an agreement to pay back the loan and what steps need to be taken to pay it back. However, it only outlines what the borrower needs to do and any consequences of not adhering to the promissory note.
Promissory Note FAQ
Why is a promissory note important?
A promissory note is important because it makes the loan official. It also helps to clearly outline the details of the loan to avoid confusion or disagreement over any terms.
What is an example of a promissory note?
An example of a promissory would be for a lump sum payment due at a certain time. For instance, you borrowed $5,000 and the promissory note stipulates you’ll need to pay it back by February 15, 2022 in installments, with interest.
What happens when a promissory note is not paid?
Promissory notes are legally binding contracts. That means when you don’t pay back your loan, you could lose your collateral. If there’s no collateral to secure the loan, the lender on the promissory note can take the borrower to court seeking repayment.
Should I use a promissory note or loan agreement?
If you borrow a small amount of money from someone you have a good relationship with, then a promissory note should suffice. However, for those who want to borrow a large amount of money and there is no existing relationship (or neither party trusts the other), then a loan agreement is best.
The Bottom Line
A promissory note is a legal promise to repay money borrowed.
People can borrow money from each other, or from banks and other lending institutions. When someone borrows money, a promissory note is written to legally protect both the payor and the payee.
The most important elements of the promissory note are the financial details as well as the dates that everyone has financial obligations. These include the amount borrowed, any interest and how it will accrue, when the payments are to be made, how much the payments will be, and the property that could be seized if you have a collateral loan.
If you are borrowing money from a lending institution, they will have someone on staff who creates a promissory note. However, if you need a promissory note for a personal loan or a loan between friends and family, you can contact a lawyer or financial professional to help you create a promissory note.
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