What Is A Promissory Note And How Does It Work?
6-Minute ReadMay 20, 2022
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 are able to see the terms of the loan clearly laid out in a written format. In most lending situations, you’ll likely sign a promissory note.
But first, what exactly is a promissory note? Let’s find out below!
What Is A Promissory Note?
A promissory note is a written contract that outlines the terms of a loan agreement. In some cases, you may hear also hear it called an "IOU," loan agreement or simply a note.
A promissory note is essentially used to convey a written promise from the borrower to repay the lender. Within the note, you’ll usually find the terms of the loan outlined. A few terms to look out for include the principal amount, interest rates, repayment timeframe and both the borrower and the lender’s signatures.
After signing a promissory note, the borrower creates 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!
When To Use A Promissory Note
A promissory note can be used in a variety of lending situations. You may need to sign one when taking out a mortgage, student loans, personal loans and more. 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 be used to finalize a less-traditional lending agreement. For example, a promissory note is a good document to formalize a borrowing agreement between family and friends.
The purpose of a promissory note is to create legal documentation of the loan. If the borrower cannot repay the loan, a promissory note can help protect the lender from a legal standpoint.
Understanding The Types Of Promissory Notes
Just as there are several types of loans, there are several types of promissory notes. Here is an overview of the most common.
Informal Promissory Note
An informal promissory note is one that isn’t offered by a traditional lender. In this case, the loan would likely be between family members and friends. Although the note would be considered 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. These promissory notes can be sold 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 would accompany a mortgage transaction or other type of real estate purchase.
A commercial promissory note is offered by a traditional financial institution or lender. In most cases, these outline 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 Should Be Included In A Promissory Note?
If you plan to issue or sign a promissory note, it’s important to understand what should be included in the document. Here’s what a promissory note will need:
- The borrower. The document should indicate the party that is obligated to repay the loan or payor.
- The lender. The payee, or party that is entitled to repayment, should be clearly indicated.
- Important dates. The document should include the current date. Additionally, it should include an effective repayment date. A promissory note can be repaid in a lump-sum or installment payments; this detail should be determined upfront.
- The amount of money borrowed. You should see the loan amount, or principal, clearly identified.
- The APR / interest rate. Most loans will have an APR or interest rate attached to repayment terms. The interest rate should be stated in this document.
- Payment dates. If you’re working with an installment loan, then the due date of the first payment should be clear. Beyond that, you should see the date when the note expires and all payment is due.
You want to make sure this information is outlined in the promissory note to avoid surprises for both the borrower and lender. Before you sign 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 case of default are sometimes not included.
Examples Of Promissory Notes
Here’s a closer look at a few examples that you may run into.
Student Loan Promissory Notes
When you take out a student loan, most lenders will require you to sign a promissory note. If you are taking out loans from private lenders, then you will likely sign several promissory notes. Each will reflect the promise of a particular loan.
If you are taking out federal student loans, then your school may allow you to sign a master promissory note. With that, you can take out 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 is not the only document required. Beyond that, 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 personal loan, you will likely sign a promissory note in the 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 and friends, you may or may not need to sign a promissory note. The decision will be left up to the person providing the loan. In most cases, it is 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 will need to sign to finalize a loan. When the borrower signs the document, they 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. As the lender, a promissory note can provide legal protection if the borrower were to default.
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