Definition and Example of a Promissory Note

A promissory document identifies the terms of a loan agreement, the lender, and the borrower. It cites how much money is being borrowed and the frequency and amount of required payments. A promissory note should also indicate the interest rate being charged and the collateral, if any. It should include the date and place where the note was issued. It should also include the signature of the borrower.

How a Promissory Note Works

A promissory note can be either secured or unsecured. An unsecured promissory note pertains to a loan that's made based solely on the maker's ability to repay. A secured promissory note means the loan is secured by an item of value, such as a house.

Types of Promissory Notes

There are several types of promissory notes. The differences hinge on the type of loan involved and the information the note contains:

• Informal or personal: This type of note could be from one friend or family member to another.
• Commercial: These notes are more formal. They spell out the specific conditions of a loan.
• Real estate: This promissory note accompanies a mortgage or other real estate purchase arrangement.
• Investment: A company can issue a promissory note to raise capital. These notes can also be sold to other investors. Only savvy investors with the required resources should assume the risks of buying these notes.1

Promissory notes can also vary depending on how the loan is to be repaid:

• Lump sum: The entire loan amount is to be repaid in one payment.
• Due on demand: The borrower must repay the loan when the lender asks for repayment.
• Installment: A specified schedule of payments determines how the loan is to be paid back.
• With (or without) interest: The agreement should spell out the rate of interest, if any.

Promissory Notes vs. Mortgages

A loan and a promissory note are similar, but a loan is much more detailed. It describes what will happen if the borrower defaults on payments. The lender holds the promissory note while the loan is being repaid. Then the note is marked as paid. It's returned to the borrower when the loan is satisfied.

The promissory note records a promise to pay. The mortgage, also known as a "trust deed" or "deed of trust," records what happens if the borrower defaults. The lender would probably have the recourse of foreclosure.2

The mortgage secures the promissory note with the title to the house. It's also recorded in the public records. Promissory notes are generally unrecorded.

Requirements for Promissory Notes

Every state has its own laws regarding the essential elements of a promissory note, but they often include similar elements:

• The payor: This is the person who promises to repay the debt.
• The payee: This is the lender, the person or entity that's lending the money.
• The date: This is the date the promise to repay is effective.
• The amount or principal: This identifies the face amount of the money borrowed by the payor.
• The interest rate: The interest rate being charged is often stated. It can be simple interest, compounded interest, or it might detail some other calculation of interest.
• The date the first payment is due: The first payment date might be the first day of the month and every subsequent first day of the following months until the loan is paid off.
• The date the promissory note ends: This date could be the last payment of an amortized loan, a type that is paid off in a series of even and equal payments on a certain date. Or it could be a balloon payment. This would make the entire unpaid balance due on a specific date in one lump sum.

Many promissory notes don't include a prepayment penalty, but some lenders want to be assured of a certain rate of return. This could be reduced or eliminated if the payor pays off the promissory note before its maturity date, so a prepayment penalty might be included. A common penalty might equal the sum of six months' unearned interest.

Promissory notes are binding documents, so there are consequences for not following their terms. You could lose your home to foreclosure if you fail to repay a loan that's secured by the property. The lender would have the right to take you to court, to send the debt to a debt collection agency, or to report to the credit agencies.

Can I Write My Own Note?

Writing a binding, enforceable promissory note can help avoid disagreements, confusion, and even tax troubles when you're borrowing from an individual. It can be a simple contract between the borrower and the lender. Think about hiring a lawyer to create one for you if you want to be absolutely sure that all parts of your promissory note are correct.

State usury laws could affect a promissory note. They set a maximum rate of interest that can be charged. Lenders must charge an interest rate that reflects fair market value. Be sure you're familiar with your state's laws if you're going to write your own note.

The IRS takes an interest in loans as well, so it can be helpful to understand tax law. Interest earned by a lender is considered to be taxable income. The IRS can impose its own rate of interest on below-market loans. It can force the lender to pay taxes on that amount when no interest is being charged. A borrower could be taxed on the forgiven amount as income if the lender forgives the loan and waives repayment.

A qualified tax professional can help if these tax implications seem too complicated to handle on your own.