What Is a Promissory Note?
Definition and Examples of Promissory Notes
A promissory note is a written agreement regarding borrowed money. It's a promise to pay, and it should contain the terms of the agreement to do so. A bank can issue a promissory note, but so can an individual or a company or business—anyone who's lending money.
A promissory note isn't a contract, but you'll likely have to sign one before you take out a mortgage.
What Is a Promissory Note?
Promissory documents identify the terms of a loan agreement, the lender, and the borrower. They cite how much money is being borrowed, and the frequency and amount of required payments. A promissory note should also indicate the interest rate being charged and the collateral, if any. It should note the date and place where the note was issued, and include the signature of the borrower.
How a Promissory Note Works
A promissory note can be either secured or unsecured. An unsecured promissory note pertains to a loan that's 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 are enforceable legal documents. The borrower can be sued if they default on the agreement and the loan's terms.
Types of Promissory Notes
There are several types of promissory notes. The differences hinge on the type of loan involved and the information the note contains:
- Informal or personal: This type of note could be from one friend or family member to another.
- Commercial: These notes are more formal and spell out specific conditions of a loan.
- Real estate: This promissory note accompanies a home loan or other real estate purchase.
- Investment: A company can issue a promissory note to raise capital, and these 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 depending 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 to be paid back.
- With (or without) interest: The agreement should spell out the rate of interest, if any.
Promissory Notes vs. Mortgages
A loan and a promissory note are similar, but a loan is much more detailed and describes what will happen if the borrower defaults on payments. The lender holds the promissory note while the loan is being repaid, then the note is marked as paid and returned to the borrower when the loan is satisfied.
Promissory notes aren't the same as mortgages, but the two often go hand in hand when someone is buying a home.
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. For example, the lender would probably have the recourse of foreclosure.
The mortgage secures the promissory note with the title to the house, and it's also recorded in the public records. Promissory notes are generally unrecorded.
|Promissory Note||Mortgage or Loan|
|Is a promise to pay||Details a lender's recourse if the loan isn't paid, such as foreclosure|
|Kept by the lender until the loan is paid off||Returned to the borrower when the loan is paid off|
|Is generally not recorded||Recorded in public records|
Requirements for Promissory Notes
Every state has its own laws regarding the essential elements of a promissory note, but must typically include similar 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's lending the money.
- The date: This is the date the promise to repay is effective.
- The amount, or principal: This identifies the face amount of the money borrowed by the payor.
- The interest rate: The interest rate being charged is typically stated. It can be simple interest, compounded interest, or some other way 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 day of the following months until the loan is paid off.
- 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 be a balloon payment, which would make the entire unpaid balance due on a specific date.
Many promissory notes don't contain a prepayment penalty, but some lenders want to be assured of a certain rate of return and this 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' unearned interest.
Promissory notes are binding documents, so there are consequences for not following their terms. For example, you could lose your home to foreclosure if you fail to repay a loan that's secured by the property. The lender would have the right to take you to court, send the debt to a debt collection agency, or report to the credit agencies.
Can I Write My Own Note?
Writing a binding, enforceable promissory note can help avoid disagreements, confusion, and even tax troubles when you're borrowing from an individual. It can be a simple contract between the borrower and the lender. But consider hiring a lawyer to create one for you if you want to be absolutely sure all parts of your promissory note are correct and legally binding
Having a professional draw up your promissory agreement is especially worthwhile if a large amount of money is involved.
There are also state usury laws that could affect a promissory note because they set a maximum rate of interest that can be charged to a borrower. Lenders must charge an interest rate that reflects fair market value, so you should be familiar with your state's laws if you're going to write your own note.
The IRS takes an interest in loans as well, so it can be important to understand tax law. Interest earned by a lender is taxable income. The IRS can impose its own rate of interest on below-market loans and force the lender to pay taxes on that income when no interest is being charged. In fact, a lender could be taxed on the forgiven amount as income if the lender forgives the loan and waives repayment altogether.
A qualified tax professional can help if these tax implications are too complicated for you to handle comfortably.
- A promissory note is a written and signed promise to pay back borrowed money.
- The document identifies the terms of a loan and the parties to the loan, but it doesn’t detail what will happen if the borrower defaults.
- A promissory note can be either secured or unsecured, depending on the terms of the loan.
- Promissory notes are binding, legal documents, although they’re rarely recorded in public record.