Promissory Note: Definition, When To Use, What's Included

What Is a Promissory Note?

A promissory note is a written promise to pay within a specific time period. This type of document enforces a borrower's promise to pay back a lender by a specified period of time, and both parties must sign the document.

A promissory note is not the same as a contract. A contract details all the terms of a legal agreement. A promissory note typically covers the following elements:

• The date by when someone needs to be paid
• How a person or organization needs to be paid
• How much a person or organization needs to be paid

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Promissory notes are common documents in any financial service. You've likely signed one if you have taken out any type of loan in the past.

You may also encounter a promissory note referred to as:

• Commercial paper
• Demand note
• IOU
• Loan agreement
• Notes payable

A promissory note establishes a clear record of a loan, either between individuals or between entities. By placing all relevant details in writing, a promissory note ensures clarity on due dates for payments and the amount of payments.

When Should I Use a Promissory Note?

A promissory note is commonly used for the following transactions:

• Business loans
• Car loans
• Mortgages
• Personal loans among friends or family
• Student loans

If you are lending a person or a business money, you may want to formalize the loan by creating a promissory note. A promissory note is especially important if you are lending a large amount of money. The promissory note functions as a legal record of your loan, helping to protect you and to ensure that a person or organization repays you.

Common types of promissory notes include the following:

• Commercial: These notes are more formal and detail specific conditions of a loan.
• Investment: A company can decide to issue a promissory note to raise capital. The company can also sell these notes to other investors.
• Personal or informal: These notes generally involve one family member or friend loaning a sum of money to another family member or friend.
• Real estate: These notes accompany a home loan or other real estate purchase.

What Should I Include in a Promissory Note?

A promissory note should include all terms and details to which both parties of a loan are agreeing. Since every state has its own laws governing the essential components of a promissory note, you'll want to verify the laws of your state. State-specific laws can greatly impact the enforceability and terms of a promissory note.

Important details any promissory note should state include the following:

• Payor or borrower: Include the name of the party who promised to repay the stated debt
• Payee or lender: Include the name of the lender, the person or entity, lending the money
• Date: List the exact date the promise to repay is effective
• Amount or principal: State the face amount of the money borrowed
• Interest rate: If the loan involves interest, the promissory note should include the interest rate charged. The interest rate may be simple or compounded. There are usury laws in many jurisdictions that limit the amount of interest a lender can charge for a loan.
• Date first payment is due: A common arrangement is to have the first payment due on the first day of the month and subsequent payments due on the first date of the following months.
• Details of each payment: If multiple payments are due, the promissory note should include how often payments will be made as well as the amount of each payment.
• Date the promissory note ends: In the case of an amortized loan, a loan paid off in a series of even and equal payments on a specified date, the date the note ends could be the last payment. An agreement could also involve a balloon payment, specifying a date on which the entire unpaid balance is due.
• Signatures: Make sure signatures of both the borrower and the lender are included on the promissory note. For most jurisdictions, a promissory note needs signatures to be legally enforceable. It is worth noting that some jurisdictions may enforce a promissory note even if only signed by the borrower, provided other conditions are met.

Types of Promissory Notes

Different types of promissory notes are appropriate for different types of agreements. You should create your promissory note to fit the type of transaction in which you're involved. Promissory notes can be as simple as a one-time payment from a friend. Transactions such as car loans and mortgages require more complex promissory notes that cover details such as amortization schedules, interest rates, and more.

Types of promissory notes include the following:

• Simple promissory note
• Demand promissory note
• Secured promissory note
• Unsecured promissory note

Simple Promissory Note

If you're writing a promissory note for a lump sum repayment, you'll typically use a simple promissory note. An example is lending your sibling $2,000. Your sibling agrees to pay you money back by January 1. A simple promissory note will state the full amount is due on the stated date; you won't need a payment schedule. You can decide whether to charge interest on the loan amount and include the interest in the document if needed.

Demand Promissory Note

A demand promissory note makes payment due when the lender asks for the money back. You will typically need to provide a reasonable amount of notice to use this type of promissory note.

Secured Promissory Note

A secured promissory note secures the amount loaned with an asset of value, for example, a home or vehicle. If the borrower does not pay back the loan amount within the agreed-upon time frame, the lender has the right to seize property of the borrower. This often involves a legal process the lender needs to go through in order to seize the property.

For example, when you buy a house, the house is collateral on your mortgage. Your bank can seize your home if you do not make stipulated payments by way of a legal process.

Unsecured Promissory Note

This type of promissory note does not allow the party lending the money to secure an asset for the loan. If the borrower does not make the payment, the lender must instead file in small claims court or go through other legal processes to enforce the note.

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What Happens When a Promissory Note Is Not Paid?

Promissory notes are legally binding documents. Someone who fails to repay a loan detailed in a promissory note can lose an asset that secures the loan, such as a home, or face other actions.

You have a few options if someone who has borrowed money from you does not pay you back. First, you should ask for the repayment in writing. A written reminder might be all you need to do to get your money paid back. Past due notices are commonly sent at 30, 60, and 90 days after the stated due date.

If the borrower still does not pay you back, you might consider asking your borrower to make a partial payment. You can create a debt settlement agreement if you decide to accept partial repayment of a debt. You may also consider creating an extended payment plan that allows the borrower to pay you back in full over a revised period of time.

You can also choose to use a debt collector to obtain repayment. A debt collector works with you to collect the note, generally taking a percentage of the payment. Alternately, you can sell the note to a debt collector. Selling a note to a debt collector gives the debt collector ownership of the loan and the ability to collect the full amount. It is more common to assign debt to a debt collector, though.

If nothing else works, you can also sue your borrower for the full amount owed to you.

When writing a promissory note, make sure to include all important details to protect yourself. Get in touch with an experienced lawyer for help drafting your document.