You have probably heard the term promissory note, but do you understand what a promissory note is and when one can and should be used? A promissory note is simply a written promise to repay someone who has loaned you money. More specifically, it sets forth the terms for repayment of a loan on or by a specified date. A promissory note can also require repayment on demand (when the note is presented for payment) or in installments over time until a specified future date.
Promissory notes are legally enforceable and are often used by companies and individuals to obtain financing from sources other than financial institutions. The alternative funding source may be a person, another company, or an investor—any person or entity that is willing to provide the financing to the issuer under certain mutually agreed-upon terms. This type of arrangement allows almost anyone to become a lender for any (legal) reason.
Promissory notes can be described as a hybrid of a loan contract and an IOU. However, there are a few important differences that must be understood. An IOU is a flexible informal statement that money is owed, but unlike a promissory note, it may not include detailed terms for repayment and thus may not be legally enforceable. Conversely, a loan contract is a complex, legally enforceable agreement that specifies what the lender can do to recover money owed (such as foreclosure) in the event the borrower fails to make payments owed. A promissory note does not usually contain the specific measures of a loan contract that can be taken if the issuer fails to make payment. Further, in the financial world, promissory notes can be sold.
A promissory note typically contains the following information:
- Name of lender
- Name of borrower
- Amount of debt owed (original principal amount)
- Nature of or reason for the debt
- Description of any collateral (item pledged for repayment of note)
- Frequency and size of repayments
- Interest rate
- Date and place the note was first made
- Maturity date for the note
- Signature of person who owes money to someone else (issuer)
There are many different types of promissory notes. Here are some of the most common types:
- Basic note. This type of note simply serves as a promise that a debt will be repaid to the lender by the borrower and does not normally state a purpose.
- Installment payment note. This type of note is often used when buying a car or major appliance. Often the dealership or store will offer an option to purchase the item and use a note setting forth the down payment and regular (installment) repayment terms. These notes generally have higher interest rates, and lenders often do not allow prepayment of the loan balance.
- Real estate note. This promise to repay a loan used to purchase real estate is one of the most common types of notes. Like an installment note, a real estate note typically requires regular installment payments of the principal and interest and may require a final balloon payment. At the end of the term, the note may permit the borrower to elect to either pay the remaining balance (balloon payment) or reset the loan term at a higher interest rate. Normally, the real property being purchased is used as collateral to secure this type of note.
- College loan note. A college loan note is commonly used to document a student's obligation to repay funds used for education expenses. A private lender may require a separate note for each loan the student takes out. Some schools permit students to sign one master promissory note allowing the student to receive several federal loans conditioned on the school's certification of the student's eligibility. These types of notes include the student's contact information as well as contact information for the student's personal references.
- Commercial note. If you borrow from a commercial lender, the note may state that full repayment is due immediately if you miss a payment or series of payments. The lender may include a provision allowing the lender to file an action to seize the collateral if the payments are missed.
- Investment note. Instead of obtaining a loan from a bank, business owners often execute an investment note to borrow money from investors to use as capital for their business in exchange for specified repayment terms or ownership in the business.
- Personal note. This type of note usually documents a loan agreement between friends or relatives and may include flexible repayment terms allowing the borrower to make payments without imposing a specific due date.
If a borrower stops making payments or does not repay the loan in full, the lender must enforce the note in accordance with its terms. If the note is secured by collateral, then the lender has the option to seize the collateral according to the terms of the note. If the note is not secured by collateral, the enforcement process is more complicated. In either event, the lender should make an effort to communicate with the borrower to try to reach an agreement. The lender may need to send a demand letter, hire legal counsel, or file an action in court to collect payment.
Because of their frequent use in business (and personal) contexts, promissory notes are vital to our financial world. Understanding them and the different ways they can be used is essential for you and your business. It is also important for a promissory note to be well-drafted. We can help ensure that the promissory notes you execute on behalf of your business properly reflect your agreements with your lenders.