What Is a Promissory Note?
A promissory note is a legally binding written agreement that includes specific details about a loan’s terms. When a payer and payee (also known as a borrower and lender) sign a promissory note, they must uphold their ends of the deal.
The word “promissory” stems from the root word “promise.” With a promissory note, the borrower essentially promises to repay the lender. Individuals and companies often use promissory notes instead of more formal loan contracts, but they still protect the lender much like a contract would.
What is included in a promissory note?
Not every promissory note is exactly the same, but they often include similar information related to the terms of a specific loan. They tend to have:
- Names of lender and borrower
- Amount of money borrowed (also known as the principal)
- Repayment schedule
- Maturity date
- Interest rate on the loan
- Monthly payment amounts
- Collateral (if it’s a secured loan)
- Late payment penalties
- Signatures of lender and borrower
The specific information in the written agreement may depend on how the loan is used. For example, a promissory note between a home seller and buyer should have information about the property, such as the property’s address or its appraised value.
For secured loans, the promissory note may also contain specific details about what would happen if the loan goes into default (like a potential foreclosure).
How are promissory notes used?
Individuals, businesses and other entities use them for loan agreements. While they may not be as detailed as a formal loan contract, which banks and loan companies tend to use, promissory notes still are legally enforceable and give the borrower an obligation to repay the loan according to the terms laid out in the document.
If an individual wants to give someone a loan — perhaps to help them start a small business — they may agree to use a promissory note instead of having a lawyer draft a contract. Once the borrower and lender sign the document, both will have to abide by those terms.
This offers the lender more protection than a simple verbal agreement. Even if the new entrepreneur is borrowing money from a friend, that friend may still want to ensure the debt will be repaid. If the business fails, for whatever reason, the borrower would still have to abide by the loan’s terms. If they don’t, the lender could take them to court.
When to use a promissory note
Generally, they’re used for smaller loan amounts or loans between individuals. Promissory notes protect not only the lender but the borrower as well. Instead of a verbal agreement (or even an IOU), which are easier to dispute in the event of a disagreement, promissory notes hold each side of the loan accountable.
For more significant loans, a loan contract may be a better alternative.
Different types of promissory notes
Most promissory notes share similar characteristics, but there are some notable differences:
- Master: The Department of Education issues master promissory notes to originate student loans. A master promissory note is one of many types of student loans that borrowers use to pay for college.
- Secured: Secured loans involve collateral, which is property the borrower can use to back up the loan. In the event of default, the lender can seize the collateral. Auto loans and mortgages are common types of secured loans.
- Unsecured: Unsecured loans rely on the good faith and credit of the borrower instead of collateral. Unlike secured promissory notes, unsecured ones aren’t backed by physical property. Typically, interest rates are higher for unsecured loans.
- Convertible: Businesses may use convertible promissory notes to borrow money from investors, which give investors the option to convert outstanding debts into an ownership stake in the company under certain circumstances.
- Demand: Lenders can use a demand promissory note to demand payment at any time from the borrower. Unless the lender triggers the clause and demands payment from the borrower, the debt does not have to be repaid.
- Negotiable: Most promissory notes can be transferred — meaning that the lender can transfer the debt to another third party at their discretion. “Negotiable” in this context does not necessarily mean that the terms of the document can be renegotiated after signing.
- Non-negotiable: Some promissory notes include language that makes it so they cannot be transferred to a third party. This prevents debts from being sold to a debt collection agency, for example.
How to write a promissory note
1. Draft the document
You can draft it yourself, and you might want to consider a promissory note template available online. Make sure to include important information like the terms of the loan, the date of the transaction, each party’s mailing address and any other relevant information you may need.
2. Review the terms
Both parties should carefully review the document to ensure they’re willing to accept the terms of the loan. Chances are that if you’ve already written up a promissory note, you’ve already negotiated the loan’s terms to some extent, but this is another opportunity to iron out any details.
3. Sign the document
Once the document has been signed, it’s legally enforceable. The last step in writing a promissory note is signing it, much like any other formal legal document. Your signature is legally binding.
How to make changes to a promissory note
A promissory note can be changed if both parties agree to those particular changes. For example, if both sides want the loan to be paid off more quickly, they can add an addendum to the promissory note and change those terms. Changes are as binding as the original note, but they should be done in a formal way — both parties will have to sign the document again.