A promissory note is essentially a written promise to pay someone. This type of document is common in financial services and is something you've likely signed in the past if you've taken out any kind of loan. If you decide to lend money to someone, you may want to create a promissory note to formalize the loan.
What is a promissory note?
Promissory notes may also be referred to as an IOU, a loan agreement, or just a note. It's a legal lending document that says the borrower promises to repay to the lender a certain amount of money in a certain time frame. This kind of document is legally enforceable and creates a legal obligation to repay the loan.
Key components
Promissory notes are relatively straightforward, typically involving just two parties: the borrower (the “maker”) and the money lender (the “payee”). It's possible to create a secured promissory note (backed by collateral or assets) or an unsecured promissory note, depending on the type of debt.
Regardless of the type, here’s what a promissory note typically contains:
- Identification. Full names and addresses of the maker and payee.
- Loan details. The amount borrowed, interest rate (if applicable), and repayment terms, including the payment schedule and maturity date.
- Security or collateral. Description of assets used to secure the loan (not applicable to unsecured promissory notes).
- Default and late payment terms. Conditions that constitute a loan default and any penalties for late payments.
- Prepayment terms. Information on early repayment options and any associated fees.
- Signatures and dates. Both parties must sign and date the document for it to be legally binding.
Like other legal documents, promissory notes typically contain miscellaneous terms or sections, such as clauses for how to handle disputes. It’s also a good idea to notarize the note, especially for informal agreements that are more likely to be disputed.
Promissory note examples
To better understand how promissory notes work in practice, let’s review two potential examples of how they can be used:
1. Personal loans between family members
Close friends and family members might use a promissory note to formalize a personal loan. For instance, a recent college graduate could borrow $5,000 from their parents to cover moving expenses for a new job. In this situation, the promissory would typically include these terms:
- The $5,000 loan amount and any agreed-upon interest rate charges
- A repayment schedule (e.g., $200 monthly for 25 months)
- Any consequences for late or missed payments
As long as both parties agree, the promissory note effectively acts as a legally binding contract and holds the recent graduate responsible for repaying their parents.
2. Car loan promissory note
When financing a car purchase, most lenders require the buyer to sign a promissory note with the loan contract that has the following components:
- Total amount borrowed
- The annual percentage rate (APR) and loan term (e.g., 5% APR for 60 months)
- Monthly payment amount
- Information about late penalties and consequences (e.g., the lender’s right to repossess the vehicle in the event of a default)
The lender holds the promissory note until the borrower repays the loan, after which it expires (similar to a lien). In other cases, the lender can use the promissory note to collect debts if the borrower doesn’t follow through with the terms.
When to use a promissory note
A promissory note is used for mortgages, student loans, car loans, business loans, and personal loans between family and friends. If you are lending a large amount of money to someone (or to a business), then you may want to create a promissory note from a promissory note template. This note will be a legal record of the loan and will protect you and help make sure you are repaid.
Still, it’s crucial to understand the implications before you create or sign a promissory note. Here are some advantages and drawbacks to keep in mind:
Pros
- Protection. A promissory note protects the lender’s and borrower’s interests by clearly outlining each party’s obligations and rights.
- Flexibility. These notes can be used in various lending situations, from personal loans between friends to formal business transactions.
- Easier to obtain. In certain situations, securing a loan through a promissory note may be easier than going through a traditional bank.
- Maintain relationships. A promissory note can clarify expectations and prevent conflicts when used in informal situations with friends and family.
Cons
- Doesn’t eliminate all risks. While a promissory note provides legal protection, there’s always a chance the borrower might miss payments or default on the loan entirely.
- Requires careful drafting. Like other legal documents, a promissory note must contain the necessary information and comply with local laws in order to be enforceable.
- May not cover all contingencies. In complex lending situations, a simple promissory note might not address all possible scenarios or complications that could arise.
Given the potential risks, it’s advisable to consult an attorney—especially if you’re not comfortable working with legal documents or have any questions about your promissory note.
What to include in a promissory note
A loan promissory note sets out all the terms and details of the loan.
The promissory note form should include:
- The names and addresses of the lender and borrower
- The amount of money being borrowed and what, if any, collateral is being used
- How often payments will be made in and in what amount
- Signatures of both parties, in order for the note to be enforceable
The collateral referenced above is a property that the lender can seize if the note is not repaid; for example, when you buy a home, the house is the collateral on the mortgage.
How to customize a promissory note
Promissory notes should be created to fit the transaction that you are involved in. It's always good to refer to a sample promissory note when you are writing one so that you can be sure to include the right language. There also are different types of promissory notes.
A simple promissory note might be for a lump sum repayment on a certain date. For example, let’s say you lend your friend $1,000 and he agrees to repay you by December 1st. The full amount is due on that date, and there is no payment schedule involved. There may or may not be interest charged on the loan amount, depending on what you've agreed.
A demand promissory note is one in which payment is due when the lender asks for the money back. Usually, a reasonable amount of notice is required.
More complicated promissory notes for transactions like mortgages and car loans will also include interest rates, amortization schedules, and other details.
How to collect on a promissory note
If you've lent money to someone using a promissory note, the plan is for them to repay you according to the terms of the note, which in most cases is what happens. But what if they don't meet the terms of the note?
The first thing to do is actually to ask for the repayment in writing. A written reminder or request is often all that is needed. You could send past due notices 30, 60, and 90 days after the due date.
Be sure to talk to your borrower. Can they make a partial payment? Would an extended payment plan allow them to pay up? If you decide to accept a partial repayment of the debt, then you can create a debt settlement agreement with your borrower.
Another option is to use a debt collector. This business will work to collect your note and will usually take a percentage of the debt. You also can sell the note to a debt collector, meaning they own the loan and collect the full amount (this is similar to what happens when banks sell loans to each other). If all else fails, you can sue the borrower for the full amount of the debt.
Promissory notes are a useful way to establish a clear record of a loan—whether between entities or individuals—and to put all the relevant terms in writing, so that there can be no question about the amount of money lent and when payments are due.
What happens if a promissory note is not paid?
When borrowers fail to meet the repayment terms, they officially default on the loan. This situation can lead to several consequences:
- Credit score impact. If the lender reports the default to credit bureaus, the borrower’s credit score can drop significantly, affecting their ability to secure loans in the future.
- Collateral seizure. With secured promissory notes, the lender may have the right to seize specific property to pay back the loan.
- Legal action. As a last resort, the lender may file a lawsuit against the borrower to recover the unpaid debt. If successful, the court may allow the lender to garnish wages or place liens on the borrower’s property, depending on the jurisdiction’s laws and the type of debt.
Litigation can be costly and time-consuming for both parties, which is why many lenders pursue alternative solutions, as previously discussed. In these situations, it’s highly recommended to consult an attorney to protect your rights.
FAQs
What are the different types of promissory notes?
Generally speaking, promissory notes can be categorized as secured (backed by collateral) or unsecured. Common types include promissory notes for mortgage loans, federal student loans (also known as a master promissory note), auto loans, and personal loans between friends or family, among other potential uses. It's important to note that bills of exchange and promissory notes are not the same.
Is a promissory note legally binding?
Yes, a properly executed promissory note is legally binding. As long as the note contains all necessary elements, is signed by the involved parties, and complies with local laws, it’s enforceable in court if the borrower defaults or fails to meet their obligations.
Can a promissory note be transferred or sold?
Yes, a lender may sell or transfer a promissory note to a debt collector if the borrower defaults. Some businesses might purchase promissory notes as well, but this is more common in institutional or corporate investments with high regulatory oversight.
Can you write your own promissory note?
Yes, you can write your own promissory note. However, it’s advisable to consult an attorney to ensure the legal document is valid and legally enforceable. It’s also a good idea to get your promissory note notarized to prevent future disputes.
Who owns a promissory note?
The lender—known as the payee—is typically the owner of the original promissory note until the borrower repays the loan. In some cases (like for a mortgage loan), the note may also be held by a financial institution or investment group.
Brette Sember, J.D. contributed to this article.
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