A promissory note is a legal document that includes a signed statement in which a specific individual (the “borrower”) commits to repay the other person (the “lender”) a designated amount of money, either by a specified date or upon request, along with any other agreed-upon conditions.
Understanding what a promissory note is can be crucial for anyone involved in lending or borrowing money. In this guide, we will answer questions such as:
What is a promissory note used for?
When do you need to use it, and how does it work?
Therefore, keep reading to understand the nature of this widely used financial tool.
What is a Promissory Note and How Does it Work?
A promissory note is a legal instrument used to formally acknowledge the borrower's obligation to repay borrowed money to the lender under specified terms.
Legally, a promissory note functions as a contract that formalizes the agreement between parties concerning the amount borrowed and the terms for its repayment.
So, the primary purpose of a promissory note is to outline the specific terms of the agreement made between the parties regarding borrowing money. When all details are included in writing, the agreement is recognized by law, making it legally enforceable.
As a result, when the agreed-upon terms are documented—such as the party's identification, the amount borrowed, the repayment date, and any other relevant conditions—and the promissory note is signed, the borrower is formally committed to repay the loan as stipulated.
When Do You Need to Use a Promissory Note?
A promissory note should be used whenever money is borrowed or lent, as it serves as formal, written evidence of the transaction detailing the specific terms of any type of loan. In this way, the document provides both the lender and borrower with a clear understanding of repayment expectations.
Moreover, with a written record, the lender can take legal action if repayment is not made according to the terms. Therefore, using a promissory note for loans is essential to document it and secure its repayment.
In some cases, a promissory note is even mandatory, such as when borrowing from a bank. In real estate transactions, a promissory note acknowledges the borrower's debt and repayment commitment, while the mortgage secures the loan with a lien on the property.
Therefore, if the borrower does not fulfill their obligations as stated in the promissory note, the lender can recover their claim by selling the property, as permitted by the mortgage agreement. So, understanding the distinction between a note vs. mortgage can help clarify their unique roles in a loan agreement.
Secured vs. Unsecured Promissory Note
The most common promissory note types are secured and unsecured, which differ depending on whether the loan is backed by collateral. Knowing what a promissory note is in this context can help parties choose the appropriate type for their needs.
A secured promissory note involves a loan that is guaranteed by collateral—assets like a car, real estate, or other valuable property. This guarantee is advantageous for the lender because if the borrower fails to repay the loan, the lender has the right to seize the specified asset to cover the remaining debt.
On the other hand, an unsecured promissory note is not backed by any collateral. This type of loan is riskier for the lender because they can only rely on the borrower's promise to repay the debt. So, if the borrower fails to pay, the lender can seek repayment only through legal channels, which can be lengthy.
In conclusion, the main differences between a secured and unsecured promissory note are collateral and risk. Secured notes, backed by collateral, are less risky for lenders and generally come with lower interest rates.
In contrast, unsecured notes lack collateral, increasing the lender's risk and usually resulting in higher interest rates.
Other Types of Promissory Notes
Besides secured and unsecured promissory notes, there are several other types that help clarify what a promissory note is and how it can be used:
Promissory Notes Types
Demand Promissory Note: This note allows the lender to demand repayment at any time. The borrower doesn't have a fixed timeline, so they must repay the loan as soon as the lender demands it.
Installment Promissory Note: This type highlights what a promissory note is when the borrower agrees to repay the loan through a series of regular, fixed payments, such as monthly or quarterly. Each payment includes both principal and interest.
Open-Ended Promissory Note: An open-ended promissory note allows for multiple loans under one agreement. The borrower can continue to draw funds up to a specified limit and only pay interest on the outstanding balance.
Master Promissory Note: This note type is primarily used in education financing and allows the borrower to take out additional funds under the same agreement without signing a new note each time. So, it basically covers the first student loan and any other loans students take out after the first one.
Corporate Promissory Note: These are issued by companies to raise capital from investors or cover operating costs. They typically include a fixed interest rate and maturity date.
Promissory Note vs. Loan Agreement
A promissory note and a loan agreement are standard documents used when borrowing or lending money, but they each serve distinct roles. While they may seem similar, there are important differences between them.
A loan agreement is a formal contract between two or more parties that outlines every aspect of the loan transaction. It includes details on the parties involved, the loan amount, repayment terms, penalties, and default provisions. Loan agreements may involve additional parties, such as guarantors or co-signers, and cover complex loans, such as commercial loans.
In contrast, a personal loan promissory note is a written promise from the borrower to repay the loan as agreed. Essentially, a promissory note for a loan is a straightforward statement of the repayment terms. So, unlike a loan agreement, the promissory note does not cover the full details of the transaction.
In essence, the loan agreement regulates all aspects of the loan, whether it is a small business loan or a more complex one, whereas a promissory note for a loan addresses only the borrower's commitment to repayment under specific conditions. This main difference makes the promissory note just one part of the broader loan agreement.
What Goes on a Promissory Note?
A promissory note should include all essential components of the borrower's debt to serve as valuable proof of a loan in court.
Here's what goes on a promissory note:
Promissory Note Provisions
Title. The document should clearly state at the beginning of the document that it is a “Promissory note” to clarify its purpose. The simple heading removes any doubt about the document's intent.
Date. The creation date is crucial as it establishes the starting point for legal obligations, including the repayment timeline, due date, and interest calculation.
Borrower Information. This section provides the borrower's name, address, and sometimes even Social Security number. This information identifies the individual responsible for repaying the loan.
Lender information. Similarly, the lender's name, address, and other identifying information should be included, as this specifies who is entitled to receive repayment.
Principal amount. The principal amount is the total borrowed amount. It is a necessary detail of the promissory note as it defines the loan sum.
Interest rate. Along with the principal amount, the promissory note should include the agreed interest rate—fixed or variable and at what percentage—to calculate the total debt amount accurately.
Repayment terms. This section outlines the repayment schedule, including due dates and acceptable payment methods.
Maturity date. The maturity date specifies the final repayment deadline. This element should clearly state when the loan must be fully settled.
Signature. The borrower's signature confirms their understanding and agreement to the promissory note terms and the repayment commitment.
Default provision. This section describes the consequences if the borrower fails to make repayments as agreed, which may include penalties or legal action.
Promissory Note Example
Let’s take a look at two examples that include promissory notes, which will help you gain better insight and answer the following questions:
What is a promissory note in real estate?
What is a promissory note in law, generally?
Example 1.
Consider a loan agreement where Individual A lends Individual B $5,000 to buy a car. In return, Individual B signs a promissory note agreeing to pay Individual A back the $5,000 plus 5% interest by December 31, 2024. The note clearly states the amount borrowed, the repayment date, and the interest rate.
Example 2.
Suppose a real estate investor purchases a rental property for $200,000. They make a down payment of $50,000 and borrow the remaining $150,000 from a private lender. To document this loan, real estate investors sign a secured promissory note, promising to repay the $150,000 with 6% annual interest over 15 years.
The note states that real estate investors will make monthly payments of $1,265, including both principal and interest. Additionally, the note is secured by the property itself, meaning that if investors fail to make payments, the lender can foreclose on the property to recover the owed amount.
How to Create a Promissory Note Using Our Document Builder
Creating a promissory note for a specific loan should be precise and straightforward. Our customizable Contracts.net builder simplifies the process by guiding you step-by-step to create a promissory note tailored to your needs.
Follow these steps to draft your promissory note efficiently:
#1. Choose Your State
Begin by selecting the state where the promissory note will be executed. Each state has its own laws and requirements, so choosing the correct state ensures your document is legally compliant and enforceable.
#2. Fill Out the Basic Information
Next, enter the key details about the parties and the loan. Start by identifying the borrower and lender (such as names and addresses) to clarify who owes the repayment and who will receive it. Then, provide the principal amount and interest rate to specify the loan terms.
#3. Specify Repayment Terms
Outline the repayment schedule, which may include monthly, quarterly, or lump-sum payments, and set a final due date. If there are any prepayment options or early repayment penalties, include them here to make sure everything is understood.
#4. Customize Specific Clauses
This section allows you to add any special clauses that apply to your loan. For instance, you can include collateral terms if the loan is secured. You may also outline actions in case of default, which ensures that the promissory note fully addresses your specific needs.
#5. Review for Accuracy
Carefully review each section to make sure all information is correct. A thorough review helps prevent misunderstandings and ensures both parties are clear on the terms.
#6. Print and Sign Your Promissory Note
Print and sign the promissory note once the information is complete and reviewed. Signing the document confirms the agreement with its content and makes it legally binding.
Final Thoughts
The simplest explanation of a promissory note is that it represents a document that formally records a borrower’s commitment to repay a specified amount to a lender, complete with essential terms like the due date, interest rate, maturity date, and other relevant terms.
So, whether you are borrowing money from a friend or seeking funds for your business, having a legally binding promissory note protects both parties. However, when creating one, consider using Contract.net promissory note builder to ensure it meets all legal requirements and to make the process easier.
What is a Promissory Note FAQ
Yes, a promissory note is a legally binding document. It establishes an obligation for the borrower to repay the lender under specific terms, making it enforceable in a court of law if necessary.
Yes, a promissory note can be amended if both parties agree to the changes. This process typically requires a written amendment that clearly outlines the new terms and is signed by both the borrower and the lender.
The disadvantages of a promissory note include potential difficulty in enforcing the note if the borrower fails to repay, as there is no guarantee for the lender to recover the funds. Moreover, interest rates and terms are often more favorable and secure in formal loans from financial institutions.
A promissory note can be deemed invalid if it lacks essential elements, such as a precise amount, signatures from both parties, or specific repayment terms. It may also be invalid if it is signed under duress or without capacity.
