What Is A Promissory Note And How Does It Work?
Matt Cardwell6-Minute Read
UPDATED: July 26, 2023
Whether you want to take out a loan or formalize a private loan, a promissory note is a legal solution. With a promissory note, both the borrower and the lender can see the terms of the loan clearly laid out in a written format. In most lending situations, you’ll likely sign a promissory note.
What Is A Promissory Note?
A promissory note is a legal contract that outlines the repayment terms of a loan agreement. This contract documents in writing the agreed-upon amount of money that the borrower promises to pay the lender by a set date. In some cases, you may also hear it referred to as an “IOU,” a promissory loan agreement or, simply, a note.
A few items to look out for within the note are the principal amount, interest rates, repayment time frame and the signatures of both the borrower and the lender.
After signing a promissory note, the borrower has a legal obligation to repay the loan. As the borrower, you are promising to repay the loan according to the terms of the note. That’s what makes a promissory note so important to read.
How Does A Promissory Note Work?
Promissory notes can be written by anyone who lends money, including people and companies. A promissory note isn’t as rigid as a loan contract, so it’s not as easy to enforce. Used as a legal debt instrument, a promissory note holds more weight than a verbal or “IOU” agreement, but it’s not as firm as a loan contract stating the recourse that will occur if the borrower fails to repay.
Promissory notes can be secured or unsecured. With a secured promissory note, the borrower must secure the loan with a valuable asset that protects the lender in the event the borrower doesn’t keep their promise. With an unsecured promissory note, no collateral is put forward on the loan.
When To Use A Promissory Note
You can use a promissory note in a variety of lending situations. You may need to sign one with mortgage loans, student loans, personal loans, car loans, business loans and other transactions. If you already have a loan of any kind, you likely signed one when you finalized the loan. If you’ve taken out a mortgage loan, then a promissory note was likely one of the many documents that you signed in the closing process.
Beyond traditional lenders, a promissory note can help finalize a less-traditional lending agreement. For example, a promissory note is a good document to formalize a borrowing agreement between family members and friends.
The purpose of this written agreement is to create legal documentation of the loan. If the borrower can’t repay the loan, a promissory note can help protect the lender from a legal standpoint.
Types Of Promissory Notes
Just as there are several types of loans, several types of promissory notes exist. Next up is an overview of the most common ones.
Informal Promissory Note
Traditional lenders don’t offer informal promissory notes. In this case, the loan is likely between family members and friends. Although the note may seem informal, the legal protection that it offers the lender remains the same.
If a company is seeking to raise capital for any reason, it can issue a promissory note. The company can then sell the note to investors who are willing to take on the risk.
When you engage in a real estate transaction, a promissory note is usually involved. In this case, the promissory note accompanies a mortgage transaction or other type of real estate purchase.
A traditional financial institution or lender offers a commercial promissory note. In most cases, the note outlines the terms of the loan in a more formal way. You’ll likely find the detailed conditions of the loan in a commercial promissory note.
What Is Included In A Promissory Note?
If you plan to issue or sign a promissory note, it’s important to understand the items that should be included in the document. Here’s what a promissory note will need to include:
- The borrower: The document should indicate the name and address of the party obligated to repay the loan or payor. The document also needs to include their signature.
- The lender: The name and address of the payee, or party who’s entitled to repayment, should be clearly indicated. The lender’s signature also needs to be included on the document.
- Important dates: The document should include the current date. Additionally, it should include an effective repayment date. If you’re working with an installment loan, the due date of the first payment should be clear. You can repay a promissory note in a lump sum or installment payments, and you should determine this detail upfront.
- The amount of money borrowed and any collateral: You should see the loan amount, or principal, clearly identified along with the collateral being offered on the loan, if any.
- The APR/interest rate: Most loans will have an APR or interest rate attached to repayment terms. The document should state the interest rate.
- Late fees: The promissory note should include any late fees that the borrower may incur if they make a late payment.
To avoid surprises for both the borrower and lender, it’s best to make sure all this information is outlined in the promissory note. Before signing on the dotted line, make sure to read through everything to confirm that the details of the loan are correct.
Also keep in mind what could happen if the borrower defaults. Although the note will outline the sum of money being borrowed, the consequences in the event of default are sometimes not included.
Examples Of Promissory Notes
There are several types of promissory notes that you may encounter with everyday financial transactions. Here are a few of them:
Student Loan Promissory Notes
When you take out a student loan, most lenders will require you to sign a promissory note. If you are getting loans from private lenders, you will likely sign several promissory notes. Each will reflect the promise of a particular loan.
If you are taking out federal student loans, your school may allow you to sign a master promissory note. With that, you can receive multiple federal student loans without signing an additional promissory note. A master promissory note will indicate that you promise to repay the U.S. Department of Education based on the terms of your specific loans.
Mortgage Promissory Notes
If you hold a mortgage, you likely signed a promissory note in the closing process. With that, you promise to repay the lender for any funds required to purchase the home. Like other promissory notes, you’ll find the interest rate, principal amount and terms of the loan outlined in this document.
When you are closing on a home, the promissory note isn’t the only document required. You may also find a loan contract or other financial instruments to further solidify the loan.
Personal Loan Promissory Notes
When you agree to the terms of a loan, you will likely sign a promissory note for the personal loan closing process. In a formal lending process with a traditional lender, you should expect to sign a promissory note.
In an informal personal loan scenario between family members and friends, you may not need to sign a promissory note. The decision will depend on the person providing the loan. In most cases, it’s a good idea to lay out clear loan terms with the help of a promissory note.
A promissory note is a document that most borrowers must sign to finalize a loan. When you sign the document, you are promising to repay the loan.
You’ll find the details of the loan such as the principal, interest rate and specific dates in this document. If you’re the lender, a promissory note can provide legal protection for you if the borrower defaults.
Be sure to review your promissory note carefully when applying for a personal loan or any other type of loan.
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