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What is a promissory note and how does it work?

What is a promissory note and how does it work?

You'll likely be asked to sign a promissory note if you borrow money from a bank or other lender. A promissory note can be issued to individuals or businesses to outline the details of a financial loan.

Here's everything you need to know about promissory notes and their relationship to your financial loan.

What is a promissory note?

A promissory note is a written promise to pay back a definite sum of money (typically, a loan), between you (the borrower) and a lender. There are several different types of promissory notes, but each one serves as a written agreement explaining the details of a loan.

By using a promissory note, the borrower promises to abide by the loan terms set by the lender and pay back the loan according to the established interest rates and payment schedule. Individuals commonly sign promissory notes when borrowing money for personal, mortgage, student, or business loans.

If you're a business owner, you may be asked to sign a promissory note when receiving funding for your business. If you're trying to raise capital for an expansion project, for instance, your lender will present you with a promissory note that includes the details and amount of the loan.

Promissory note vs. loan agreement

It's not uncommon for the terms "promissory note" and "loan agreement" to be used interchangeably. Technically, however, a loan agreement is a different type of financial contract. A loan agreement is signed by both the borrower and the lender, while a promissory note is typically signed only by the borrower.

What is a master promissory note (MPN)?

A master promissory note (MPN) fulfills the same purpose as any other promissory note, serving as a legally enforceable agreement between the borrower and the lender. But the term "master" indicates that these promissory notes can cover multiple loans under the same agreement.

Ordinarily, you'd have to sign a new promissory note every time you borrow money. But with an MPN, the same promissory note can cover multiple loans over a certain time period. What is a convertible promissory note?

A convertible promissory note (or simply "convertible note") is most commonly used for business transactions where a company makes a promise to pay back a borrowed amount with an interest rate and maturity date. If a triggering event occurs, such as financing, the debt can be repaid with stock or equity. The term "convertible" refers to this aspect of the transaction – the ability to convert a company's debt into equity.

Types of promissory notes

In addition to master and convertible promissory notes, borrowers may encounter other types of promissory notes. The nature of the promissory note will dictate how the promise to pay is written and offer slightly different terms to the borrower.

Secured promissory note

A secured promissory note is used to explain the details of a secured loan, or a loan that requires the borrower to put up collateral to receive money. As such, a secured promissory note includes information about the collateral, as well as when and if the lender has the right to seize the borrower's property if the borrower defaults on the loan.

Unsecured promissory note

An unsecured promissory note is used for loans that include no collateral. That generally means that lenders will charge a higher interest rate, but it also means that lenders will have to take the borrower to court to demand payment for the loan.

Commercial promissory note

Commercial promissory notes are issued by a commercial lender and may include additional details related to a business transaction.

Investment promissory note

Investment promissory notes are issued to investors. An investor gives money to a company, and in exchange, the company promises to repay the investor what they borrowed plus interest or other benefits.

Real estate promissory note

A real estate promissory note is used when a borrower signs a home loan or makes any other real estate purchase.

Personal promissory note

Personal promissory notes can be used for personal loans from traditional lenders, though these may also be informal loan contracts drawn up between the borrower and a friend or family member.

What purpose does a promissory note serve?

In its most basic form, a promissory note provides a written record of a borrower’s promise to pay a loan. It ensures that both the lender and the borrower understand the amount and details of the loan, as well as the repayment terms and payment schedule.

Secondarily, a promissory note is a legally written promise to repay a loan, binding the borrower to abide by the terms detailed in the loan agreement. When lending money, banks and lenders can be more confident that they'll get their money back, along with any interest payments attached to the loan.

How does a promissory note work?

Every promissory note stipulates the means by which a borrower repays their loan. Most promissory notes contain several pieces of key information, including:

  • The name of the borrower and lender
  • The loan amount
  • Length of the loan term
  • The interest rate of the loan
  • Monthly payment amount
  • Loan repayment schedule
  • Number of required payments
  • The maturity date of the loan
  • Information about collateral (for secured loans)
  • Penalties and fees due to late payment or early repayment

The exact wording can vary between lenders, as can the loan terms and conditions. For example, some types of loans (secured loans) allow lenders to seize the borrower's assets if they fail to repay the loan.

Promissory note example

What might a promissory note look like? For the sake of illustration, consider the following promissory note example:

  • Loan Amount: $10,000
  • Interest Rate: 6.5%
  • Repayment Period: 10 years
  • Repayment Schedule: Monthly
  • Monthly Payment Amount: $113.55

Depending on the type of loan you're applying for, your lender may contain additional stipulations about penalties and fees. For instance, some lenders include an early repayment penalty, which means you can't repay the loan before its maturity date.

Looking for a promissory note template? Check one out here.

Who signs a promissory note?

Only the borrower signs a promissory note. Unlike a formal loan agreement, where both parties sign the document, promissory notes represent a borrower's unconditional promise to repay the loan balance.

How are promissory notes repaid?

Lenders can use a promissory note for different types of payment plans. The promissory note itself will include details about the interest rate, loan amount, deadlines, and more.

Here are some of the most common repayment plans used in business today.

Lump-sum payment

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Due on demand payment

If the promissory note doesn't contain information about the loan repayment schedule, the lenders may demand payment at any point. This is more common in informal personal loans and isn't wise for large loans that can be difficult to repay without planning.

Installment payment

Most financial institutions issue loans that feature an extended payment plan. Borrowers will make equal payments at regular intervals, usually once per month. Each payment will include the principal of the loan, as well as the interest.

Balloon payment

Some lenders include a balloon payment as part of the loan program, which means that after borrowers make partial repayment through a series of monthly premiums, they'll be asked to make a final large payment to settle the loan on a certain date.

Are promissory notes legally binding?

Promissory notes are legally binding documents that create a legal obligation for borrowers to repay the loan. This gives promissory notes the same legal force as a loan contract. As such, lenders can use a promissory note for payment assurance when issuing money to borrowers.

A promissory note is a formal contract

A promissory note is a legal document outlining the terms and conditions of a loan. As a legally binding document, borrowers must abide by the terms they agree to when they sign. If they fail to do so, the lender has a legally legitimate written record that proves the debt exists and the borrower has agreed to repay the loan.

Promissory notes are actually recognized by international law. The 1930 Geneva Convention of Uniform Laws on Bills of Exchange and Promissory Notes classifies these documents as formal contracts. Here in the U.S., a promissory note is enforceable by law.

Is a promissory note a security?

A security is a financial instrument that represents something else of measurable value. Stocks, for instance, are a type of security that confers a percentage of ownership in a company.

Promissory notes may also be classified as securities. Investment notes must be registered with the U.S. Securities and Exchange Commission (SEC), though these documents may be exempt from registration in rare cases.

How do you know if a promissory note is a registered security? Simply check the SEC's EDGAR database or call your local state regulator.

Do promissory notes need to be notarized?

Once the borrower signs the promissory note, it becomes a legally enforceable contract.

There's no need for the document to be notarized or otherwise witnessed by a third party. However, if a lender asks that the document be notarized, this will provide an additional degree of assurance that the borrower will make payments by the specified date.

What makes a promissory note invalid?

Though promissory notes are meant to serve as legal contracts, they can be invalidated for any of the following reasons:

  • The signature is incomplete or absent
  • The note omits key details (loan amount, interest rate, etc.)
  • The original copy is missing
  • The terms and conditions are unclear
  • The agreement contains "unreasonable" terms and conditions
  • Changes are made to the agreement but not recorded in a new agreement

The definitions of "unreasonable" or "unclear" are open to some interpretation. Most standard loans (such as student loan contracts, car loans, etc.) feature boilerplate language, but if you're entering into another type of loan, it may be wise to have a lawyer review the language before you sign.

What happens if I don't pay back my loan?

When you sign a promissory note, you're legally committing to honor its terms. If you fail to repay the loan, the lender can take legal action against you. They may hire a debt collector to retrieve their assets or sue you for the debt balance. If a loan is secured, the lender has the right to seize the secured assets.

In some cases, lenders may be willing to enter into a debt settlement agreement, which means they'll accept a partial payment to clear the debt without a prolonged legal process.

It's important to be aware that a statute of limitations is attached to different kinds of debt. The specific period varies by state and the type of debt but will generally range from three to six years. However, some states allow collection agencies to pursue bad debt for up to 10 years after the original agreement.

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