What Is a Promissory Note?
Before you take out a mortgage, you'll likely sign a promissory note. These financial documents aren't loan contracts, but they are written agreements regarding borrowed money.
Definition of a Promissory Note
Simply stated, a promissory note is a written promise to pay. These documents contain the terms of the agreement, including the lender, the borrower, how much is being borrowed, and the frequency and amount of payments. The note should also indicate the interest rate, collateral (if any), date and place the note was issued, and the signature of the borrower.
A bank can issue a promissory note, but so can an individual or a company or business—anyone lending money.
An unsecured promissory note is when a loan is made based solely on the maker's ability to repay.
A secured promissory note means the loan is secured by an item of value, such as a house.
Promissory Notes vs. Loan or Mortgage
A loan and a promissory note are similar, although a loan is much more detailed and describes what happens if the loan is not repaid. As the loan is being repaid, the lender holds the promissory note. When the loan is paid off, it's marked as such and the note is returned to the borrower.
Promissory notes are not the same as mortgages, either, although when buying a home, the two often go hand in hand. The promissory note documents the promise to pay, and the mortgage, also known as a trust deed or deed of trust, documents what happens if the borrower defaults—like foreclosure. The mortgage secures the promissory note with the title to the house and it is also recorded in the public records. Promissory notes are generally unrecorded.
The Essential Elements of a Promissory Note
Every state has its own laws about the essential elements of a promissory note. Most promissory notes involve the following common elements:
- The payor: This is the person who is obligated and promises to repay the debt.
- The payee: This is the lender, the person or entity that is lending the money.
- The date: The date the promise to repay is effective.
- The amount, or principal: The face amount of the money borrowed by the Payor.
- The interest rate: The interest rate charged. This interest rate can be simple interest or compounded interest among other ways to calculate interest.
- The date the first payment is due: An example of the first payment date might be the first day of the month and every subsequent first date of the following months.
- The date the promissory note ends: This date could be the last payment of an amortized loan, which is paid off in a series of even and equal payments on a certain date, or it could contain a balloon payment, which would make the entire unpaid balance due on a specific date.
Many promissory notes do not contain a prepayment penalty, but some lenders want to be assured of a certain rate of return, which could be reduced or eliminated if the payor pays off the promissory note before its maturity date. A common prepayment penalty might equal the sum of six months of unearned interest, for example.
Types of Promissory Notes
Before you sign a promissory note, you should know that they are enforceable legal documents. There are several types of promissory notes, which depend on the type of loan and the information the note contains:
- Informal or personal: This type of note could be from one friend or family member to another, for example.
- Commercial: These notes are more formal and spell out specific conditions of the loan.
- Real estate: A promissory note that accompanies a home loan or other real estate purchase.
- Investment: A company can issue a promissory note to raise capital, and these promissory notes can also be sold to other investors; only savvy investors with the required resources should assume the risks of these notes.
Promissory notes can also vary based on how the loan is to be repaid:
- Lump-sum: The entire loan amount is to be repaid in one payment.
- Due on demand: The borrower must repay the loan when the lender asks for repayment.
- Installment: A specified schedule of payments determines how the loan is paid back.
- With interest (or without): The agreement should spell out the rate of interest if any.
Can You Write Your Own Note?
Writing a binding, enforceable promissory note can help avoid disagreements, confusion, and even tax troubles when borrowing from an individual. It can be a simple contract between the borrower and the lender. However, if you want to be absolutely sure all parts of your promissory note are correct and legally binding, hire a lawyer to create it for you—especially when large amounts of money are involved.
There are also state usury laws that could affect a promissory note because there is a maximum rate of interest that may be charged to a borrower. Lenders must charge an interest rate that reflects fair market value. Also, the IRS takes an interest in loans; the interest earned by the lender is subject to taxation. And in some cases, if no interest is being charged, the IRS can impose its own rate of interest on below-market loans and force the lender to pay taxes on it. In fact, if the lender forgives the loan altogether, they'll be charged interest on the forgiven amount as income.
If the tax implications are too complicated for you to handle comfortably, a qualified tax professional can help.
What Happens If You Don't Pay?
Since promissory notes are binding documents, there are consequences for not following the terms. If you fail to repay a loan that is secured by your home, for example, you could lose your home. The lender will have the right to take you to court or even send the debt to a debt collection agency.