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What is a Promissory Note?
A promissory note is a written, legally binding agreement in which one person promises to pay a specific amount of money to another person either on demand or by a set date. The meaning of a promissory note refers to the borrower's promise to repay, making it legally enforceable and providing protection for both parties involved.
This document provides a clear overview of both parties' obligations and prevents potential disputes by detailing the terms of the loan, such as how much money is being borrowed, the interest rate, and when the repayment is due.
Here, it is important to explain the difference between an IOU and a promissory note, as these two documents can often cause confusion among people. An IOU is also a written document that acknowledges that one person owes another a certain amount of money.
However, unlike a promissory note, an IOU does not include detailed repayment terms and conditions and, therefore, lacks the legal enforceability that a promissory note provides. This can have potential implications if one party refuses to repay the debt, as it may complicate the process of enforcing the repayment through legal processes.
Promissory Notes Types
There are two types of promissory notes—secured and unsecured. The difference between a secured and an unsecured promissory note lies in the collateral that secures the loan. To better understand the difference, reviewing a simple promissory note template can help clarify the two types.
With a secured promissory note, there is collateral—typically property—that the lender can seize if the borrower fails to repay until the debt is repaid. On the other hand, an unsecured promissory note does not include collateral, but it still requires the borrower to meet the outlined terms, ensuring promissory note validity.
Promissory Notes by State
When Do You Need a Promissory Note?
You’ll commonly use a promissory note in the following situations:
Common Uses of a Promissory Note
Borrowing from friends or family: If you’re borrowing money from family or friends, a promissory note helps clarify the repayment terms and prevents conflicts.
Bank loans: When you take out a loan from a bank, you’ll use a promissory note to formalize your commitment to repay the borrowed money. For example, those loans might be to pay off credit cards.
Buying property: A promissory note is used for property purchases as it outlines the terms of repayment if you’re financing the purchase through a loan.
Service payments: When paying for services or large purchases over time, a promissory note can document the agreed repayment schedule between you and the provider.
Pros and Cons of Making a Promissory Note
Let’s see what the pros and drawbacks of a promissory note are.
Pros
Clarity and Formality: A promissory note provides a clear, written record of the terms and conditions of a loan or debt. This reduces the risk of misunderstandings and ensures both parties know exactly what to expect.
Legal Enforceability: Unlike informal agreements, a promissory note is legally binding, meaning that if the borrower fails to repay, the lender can use the note to pursue legal action and recover the owed amount.
Flexibility: Promissory notes can be customized to fit specific needs, including details about repayment schedules, interest rates, and collateral.
Cost-Effective: Creating a promissory note is generally a low-cost option compared to more formal loan agreements.
Cons
Potential Complexity: For more complex loans, creating a detailed promissory note might require legal advice to ensure all terms are properly addressed, which can add to the cost.
Enforcement Challenges: While promissory notes are legally binding, enforcing them may still require going to court if the borrower fails to repay the loan.
How to Make a Promissory Note in 5 Straightforward Steps
As creating a promissory note is an effective way to document and secure a loan or debt and ensure the agreement is clear, enforceable, and legally binding, we give you a simple guide to making a promissory note in five essential steps:
#1. Agree on Key Terms
The first step is to agree on the essential terms of the promissory note to ensure clarity and the purpose of creating one.
So, key terms to define include:
Amount. Specify the exact amount of money being borrowed.
Due date. Indicate when the borrower must repay the loan in full.
Interest rate. State whether interest will be charged and, if so, specify the rate and calculation method.
Repayment schedule. Detail how and when payments will be made (e.g., monthly, quarterly) and the amount of each payment.
Late fees. Outline any penalties for late payments, if applicable.
Collateral clause (optional). Describe any collateral securing the loan, such as real estate, personal property, or other assets, and state their value.
#2. Check the Borrower’s Financial Status
This step is crucial for verifying the borrower's ability to repay the loan and helps ensure further protection against the risk of non-payment.
As a result, you should evaluate the borrower:
Credit history. Review their credit score and past borrowing behavior.
Income and employment status. Ensure they have a stable source of income to meet repayment obligations.
Existing Debts. Assess their current debt levels to determine their ability to manage additional debt.
#3. Draft the Promissory Note
Once you've agreed on the key terms and reviewed the borrower's financial status, you can draft the promissory note. You can use our Contacts.net promissory note sample or builder to simplify this process by inserting and adjusting the required elements to your needs.
Essential components to include are:
Parties involved. Clearly state the names and addresses of both the borrower and the lender.
Loan details. Specify the principal amount, interest rate, and repayment schedule.
Signatures. Both parties must sign the document to be legally binding.
Date. Include the date when the promissory note is executed.
Additional clauses. Consider including options for prepayment, details on any collateral, and dispute resolution procedures.
#4. Sign the Note
After drafting the promissory note, both parties need to sign it to formalize the agreement. Signing the document confirms acceptance of the terms and obligations.
Therefore, ensure the following:
All parties sign. Both the borrower and lender should sign the document.
Witnesses or notaries. Depending on local laws, you may need a witness or notary public to validate the signatures.
#5. Enforce the Note and Repayments
After the promissory note is signed, you should monitor the repayment process to ensure compliance with the agreed terms.
Here are the key actions:
Tracking payments. Maintain records of all payments made by the borrower.
Sending reminders. If payments are missed, send reminders to encourage timely repayment.
Enforcing terms. If the borrower defaults, you may need to take legal action to enforce the terms of the note, such as seeking a court judgment.
Usury Laws & Limits by State
Usury laws are regulations that set the maximum allowable interest rates for loans. These laws protect borrowers from excessively high interest rates and ensure fair lending practices.
Therefore, if a lender charges more than the legal interest rate, the usury laws will apply and set the maximum allowable rate.
Here's a table of maximum allowable interest rates by state:
State | Usury Law Reference | Maximum Interest Rate |
Alabama | $6 per $100 for one year (verbal); $8 per $100 (written). | |
Alaska | 10,5% per year; up to 10% or 5% above the Federal Reserve rate on the day the loan is made (contractual), whichever is higher unless the loan is over $25,000. | |
Arizona | 10% per year; for contractual loans, any rate can be agreed upon. | |
Arkansas | If not specified in a contract, the rate is 6% per year, but any rate can be agreed on in contracts. | |
California | 7% per year; 10% per year for personal, family, or household loans, or higher depending on the Federal Reserve rate for other uses. | |
Colorado | Up to 45% per annum; for consumer loans (excluding supervised loans), up to 12% per annum. | |
Connecticut | 12% per annum. | |
Delaware | Up to 5% over the Federal Reserve discount rate for loans insured by the Federal Housing Administration or guaranteed by the Veterans Administration; no interest rate limit for loans over $100,000 not secured by a mortgage on the principal residence. | |
Florida | 18% per annum simple interest; 25% per annum on loans over $500,000. | |
Georgia | 5% per month; 16% per annum on loans of $3,000 or less; 7% per annum on loans greater than $3,000 but less than $250,000; no maximum interest rate limit on loans of $250,000 or more. | |
Hawaii | 10% per year; up to 12% per year for consumer credit transactions and home business loans. | |
Idaho | 12% per annum unless a written agreement specifies a different rate. | |
Illinois | 9% per annum is the general maximum interest rate. | |
Indiana | 8% per annum if the parties do not agree on an interest rate; 25% per annum for consumer loans other than supervised loans. | |
Iowa | 5% per annum, unless otherwise agreed upon in writing. | |
Kansas | 15% per annum. | |
Kentucky | The legal interest rate is 8%, but the general usury limit is either 4% above the Federal Reserve rate or 19%, whichever is lower. | |
Louisiana | 12% per annum for conventional interest. | |
Maine | 6% per year in the absence of an agreement in writing. | |
Maryland | 6% per annum, but it can go up to 8% if specified in a written contract. | |
Massachusetts | The default legal interest rate is $6 per $100 per year. 20% is the maximum interest rate per annum. | |
Michigan | 7% per annum. | |
Minnesota | $6 per $100 per year, and cannot exceed $8 per $100 per year. For contracts of $100,000 or more, there is no maximum interest rate limitation. | |
Mississippi | 10% per annum or 5% above the discount rate on ninety-day commercial paper, whichever is greater. | |
Missouri | 10% per annum, or the “market rate” if it exceeds 10% per annum. | |
Montana | 15% per year or 6% points above the prime rate published by the Federal Reserve, whichever is greater. | |
Nebraska | 16% per annum. | |
Nevada | Parties can agree on any interest rate unless their consumer credit is extended to a covered service or dependent, where the maximum annual percentage rate is limited to 36% or the lower federal limit. | |
New Hampshire | The maximum interest rate for business transactions, unless agreed otherwise in writing, is 10% annually. This does not apply to consumer credit transactions since RSA 358-K regulates them. | |
New Jersey | For general loans, the rate is 6% (without a written contract) and 16% (with a written contract), and for real property loans, it’s the bond yield plus 8%. | |
New Mexico | 15% maximum if there is no written contract. | |
New York | The maximum general interest rate is 16% per annum, with specific conditions allowing rates exceeding 6% for loans secured by real property, variable rates for demand loans, exemptions for federally insured loans and loans over $250,000 or $2.5 million, and historical rates of up to 11.25% for certain pre-1981 commitments. | |
North Carolina | For loans under $25,000, the maximum interest rate is determined by the rate announced by the North Carolina Commissioner of Banks on the 15th of each month. For loans exceeding $25,000, the parties can mutually agree to any rate in writing. | |
North Dakota | Interest on loans is typically 6% per annum unless otherwise agreed, with a maximum rate set at 7% or more based on U.S. Treasury bills. | |
Ohio | 8% per year, but it can be higher for loans over $100,000. | |
Oklahoma | The legal rate of interest is 6% unless the parties agree to a different rate allowed by current or future laws. | |
Oregon | The legal interest rate is 9%, but parties can set a different rate in a written agreement. Business and agricultural loans are capped at 12% or 5% above the 90-day discount rate of commercial paper. | |
Pennsylvania | For loans of $50,000 or less where no specific rate is agreed upon, the maximum interest rate is 6% per annum. This rate does not apply to loans over $50,000, unsecured loans above $35,000, or business loans. | |
Rhode Island | 21% per annum or the alternate rate, which is 9% plus the domestic rate published in The Wall Street Journal, whichever is higher. | |
South Carolina | 12% per year for non-supervised lenders and 18% per year for supervised lenders. | |
South Dakota | No limit with an agreement, 12% without one. | |
Tennessee | For certain transactions, it is set by specific laws; for written contracts, it is based on a formula; and 10% per year for other transactions. | |
Texas | 10% per year. If there is a written agreement, parties can agree on an interest rate, but it must stay within the applicable weekly ceiling. | |
Utah | 10% per year unless otherwise specified in the contract. | |
Vermont | The interest rate is 12% unless in the circumstances specified in subsection (b) of Sec. 41a. | |
Virginia | The legal interest rate is 6%, but the contract can specify a maximum of 12%. | |
Washington | 12% per year or 4% percentage points above the average bill rate for 26-week Treasury bills, whichever is higher. | |
Washington D.C. | 24% for written contracts and 6% for verbal contracts. | |
West Virginia | $8 per $100 per year, but for non-written contracts, it remains at $6 per $100 per year. | |
Wisconsin | The maximum interest rate is specified in Sec. 138.04; otherwise, $5 per $100 per year if no other rate is specified. | |
Wyoming | 7% per annum if no other rate is specified. |
Promissory Note FAQ
You should use a promissory note for simpler loans with clear terms, while a loan agreement is better suited for more complex arrangements with detailed terms, conditions, and collateral.
Yes, a promissory note is a legally binding document that outlines the borrower's promise to repay a loan under specified terms. It holds enforceable terms in a court of law if disputes arise.
A promissory note may be invalid if it lacks essential elements such as an explicit promise to pay, a specified amount, and signatures from both parties. Incorrect dates or incomplete information can also invalidate it.
If a promissory note is not paid, the lender can take legal action to enforce repayment, which may involve filing a lawsuit or seeking a judgment in court to recover the owed amount.
Yes, a promissory note can be transferred to another party through endorsement or assignment. The new holder can then enforce the note's terms, assuming they have legal rights to the debt.
Yes, the Contracts.net promissory note pdf builder suits personal and business loans. It helps create structured and clear promissory notes for various lending scenarios, ensuring proper documentation and terms.