A Promissory Note is a legal document that sets out the details of a loan made between two people, a borrower and a lender. The note clearly outlines the borrower’s promise to repay the lender within a specified amount of time fully.
It includes all the terms and conditions of the loan transaction and ensures the parties have a thorough and complete written record of the deal and their intentions. As such, the note should be finalized before any money changes hands. The document also acts as a formal record of the transaction.
- What Is a Promissory Note?
- Paying Back the Promissory Note
- Selling and Transferring Promissory Notes
- Tax Benefits of Promissory Notes
- What Are Promissory Notes Used For?
- How To Write a Promissory Note
- What To Include in a Promissory Note
- Example of a Promissory Note
- Promissory Note Frequently Asked Questions
What Is a Promissory Note?
A promissory note is a written, enforceable agreement (promise) between a borrower and a lender, with the borrower agreeing to pay the lender back a specific sum of money. That payment is either on-demand or within a set period of time, depending on the terms of the note.
Some examples of when you might use a promissory note include:
- Student loans
- Bank loans
- Car loans
- Personal loans between family members or friends.
A promissory note is also referred to as a:
- Debt Note
- Demand Note
- Commercial Paper
- Notes Payable
Types of Promissory Notes
There are two main types of promissory notes, secured and unsecured, and their distinction will determine how the note will be enforced in case of non-payment.
- Secured promissory note: This document is used when a borrower agrees to give up collateral (property) if they fail to repay the loan.
- Unsecured promissory note: This document doesn’t require any collateral, but a lender will often ask for higher interest rates due to a higher risk.
Paying Back the Promissory Note
You must repay the loan given through a promissory note. But there are a couple of options for doing that. Understanding those options and the consequences for missed or late payments can help you negotiate promissory notes.
What are the options for paying back a note?
You can either pay the entire sum of the promissory note or pay it in installments.
When using an installment payment option, the borrower repays the lender in set payments over time—for example, 12 monthly payments for a year. There is also the option for a promissory note to be paid in installments, with a final “balloon” payment made at the end of the agreed repayment schedule. So in a loan of $5000, the borrower could make monthly payments of $500 for six months and then make the final payment of $2000.
When repaying the entire sum of the note at once, you can either repay by a set a due date or repay “on demand” of the lender. If there is a “due on demand” payment option, the borrower must repay the lender when the lender requests that money.
What is a prepayment of the promissory note?
Prepayment means the borrower can repay the loan earlier than the due date. They can repay all or part of the loan at that time without any penalty. Some lenders require the borrower to provide them with a written notice first.
What happens if the borrower misses a payment or pays late?
Borrowers who miss a payment or pay late may be subject to late charges and other penalties. These will be based on the promissory note’s terms and must also fall within legal parameters for lending money. For example, it would be illegal to charge an interest rate higher than the usury rate of the lender’s state.
Selling and Transferring Promissory Notes
A promissory note is classified as a ‘negotiable instrument’. Negotiable instruments are signed documents that promise money to an intended party. They are inherently transferable documents and can be used as a substitute for money.
Imagine that Betty borrows $100,000 from Larry to start a 3D printing studio. Betty’s promissory note requires her to pay Larry $1,500 every month, of which $500 goes toward an annual 6% interest rate, and $1,000 goes toward principal.
The loan term is 100 months. But 20 months later, Larry decides he would like the money back sooner. He wants to invest it in his dog-walking business.
Larry can sell his note for the remaining balance, which would be $80,000 in principal plus $40,000 in upcoming interest payments. But he will need to sell it at a discount. He may sell it to Lisa for $90,000 total. Lisa then gets Betty’s monthly payments for 80 months and will make $30,000 on the deal.
Tax Benefits of Promissory Notes
Sometimes, you may want to document whether your money is a gift or a loan for tax purposes.
For example, the IRS currently allows you to gift $16,000 per individual per year without gift tax consequences. This limit is called the annual gift tax exemption. For example, your grandparents could give a combined $32,000 to each grandchild every year to reduce their estate taxes. Spouses can also gift each other $16,000 annually and claim a gift tax marital deduction.
Additionally, educational tuition expenses or medical expenses paid directly on behalf of someone else don’t count toward the $16,000 yearly gift limit. Since the IRS applies such a hefty 40% gift and estate tax, there are plenty of things you need to consider if you want to exclude gifts or estates from taxation [1] . Also, check out the IRS website for Frequently Asked Questions to understand more about gift taxes. [2]
A family loan agreement is subject to minimum IRS Applicable Federal Rates (“AFR rates”) published monthly. [3] Fortunately, the IRS-required rates are usually below commercial mortgage rates, and all the interest and principal payments stay within the family. So if you’ve maxed out your yearly giving, you can help a family member in need by using a promissory note.
What Are Promissory Notes Used For?
You should create a promissory note if you’re borrowing or lending money. It should include payment details, interest rates, collateral, and late fees. There are several types of promissory notes that you can use for different purposes, such as:
- Personal loans between family members, friends, and colleagues
- Student loans
- Real estate loans, property down payments, or mortgages (formally known as a mortgage promissory note)
- Automobile, vehicle, or car loans
- Bank, commercial, business, or investment loans
Promissory Note vs. Loan Agreement
Promissory notes and loan agreements can be effective legal ways to establish an arrangement between a borrower and a lender. In general, you should use promissory notes for straightforward loans with basic repayment structures and choose a loan agreement for more complex loan needs.
How To Write a Promissory Note
A legal promissory note must be written correctly to be legal and valid. It should have the following details and clauses:
Step 1 – Full names of parties (“borrower” and “lender”)
A standard promissory note should name who is receiving the money or credit (the “borrower”) and who will be repaid for the loan (the “lender”). Only the borrower has to sign a promissory note, but it’s also good practice to include the lender’s signature.
- The lender is sometimes called a “payee,” “seller,” “issuer,” or “maker.”
- The borrower is sometimes called a “payer” or “buyer.”
Step 2 – Repayment amount (“principal” and “interest”)
The repayment amount is the sum the borrower must pay back. Whether a simple promissory note or not, it should always state the borrowed amount. If the lender is charging interest, the note should mention it. Also, include whether the interest is compounded monthly or yearly.
If you’re unsure what kind of interest rate you should be charging, visit the Wells Fargo Rate and Payment Calculator, Prosper Loans, or the Lending Club to compare rates on personal loans. Then you can use an amortization calculator to see the principal and monthly interest payments over the life of the loan. Most states have laws that restrict the interest rate you can charge.
Check the interest requirements in your state before drafting your note. For example, a promissory note’s interest rate can’t be higher than 10% in California and Texas. In Florida, promissory notes can have a rate up to 18% (for amounts less than $500,000) or 45% (for loans greater than $500,000).
Payments on the note are applied toward interest first, with the remainder going toward the principal.
Step 3 – Payment plan
The promissory note should explain how the borrower will pay the money back. That could be by a certain date or on-demand.
Four Types of Repayment Options
| Installment Payments | Installments with Final Balloon Payment | Due on Specific Date ("Lump Sum") | Due on Demand (“Payable on Demand”) |
|---|---|---|---|
| Specific due date | Specific due date | Specific due date | No specific due date |
| Payments for principal and interest are made at regular intervals | Payments for interest only are made at regular intervals, principal amount due on maturity date | Entire amount owed, including interest, is paid all at once | Entire amount owed is due whenever the lender wants his or her money back |
| Example: $1,500 monthly payment actually consists of $500 towards the outstanding principal and $1,000 towards the interest with $1,500 due on the maturity date | Example: $500 monthly payment is applied only towards interest and full $10,000 loan amount is due on the maturity date | Example: $10,000 loan for a friend’s small business is due on a specific date | Example: $10,000 loan for a friend's small business is due at any time or whenever financially feasible |
Step 4 – Consequences of non-payment (“default” and “collection”)
Suppose the borrower cannot pay the money back on time and defaults on the note. In that case, the lender can enforce the promissory note and demand the total amount (or the collateral if the borrower used an asset to secure the note).
A refusal to pay could be met with legal action from the lender. A borrower who loses a lawsuit must pay the promissory note plus the costs associated with debt collection. That includes fees the lender paid to an attorney.
Step 5 – Notarization (if necessary)
A promissory note isn’t required to be notarized. However, it’s good to consult your state laws to verify any witness and signature requirements.
Step 6 – Other common details
A promissory note may include additional provisions, such as:
-
Acceleration: Can the lender demand immediate payment from the borrower? Possible events of acceleration include:
- if the borrower becomes bankrupt
- if the borrower fails to make payments
- if the borrower passes away
- if the borrower wants to pay off the note early
- if the borrower sells a large or material portion of their assets
- Amendment: Any changes made to the note must be done in writing.
- Collateral: If the borrower defaults, the lender has the legal right to keep the designated collateral property.
- Governing Law: Which state’s laws apply to the promissory note?
- Joint and Several Liability: This states that all co-borrowers share responsibility for the repayment of the note, collectively and individually.
- Late Charges: What penalty is charged if the amount is paid back late?
- Prepayment: It states that the borrower can pay off the debt and interest early without penalty.
- Right to Transfer: Does the lender have the right to transfer the promissory note to a different party?
Every party to the note should get a copy, and the original should be stored securely.
What To Include in a Promissory Note
It is important to know what to include in a promissory note as it ensures the document is valid and can hold up in court.
Information About the Borrower and Lender
The borrower or lender (or both) can be an individual or a company such as a corporation or LLC. If either party to the promissory note is a company, a representative must sign on the company’s behalf.
Include the lender’s and borrower’s full name and address in the promissory note as part of the contract information.
Cosigners or Guarantors
Having a cosigner or guarantor is optional. It offers protection in the case that the borrower defaults. If the borrower’s financial standing is questionable, the lender may require a cosigner for added security.
This person will jointly sign the agreement and be responsible for the debt if the borrower defaults. A cosigner typically has good credit and strong financial standing.
Payment Information
The lender needs to provide the principal amount, interest rate, repayment method the borrower will use to repay the loan, and the schedule for that repayment. Additional stipulations, such as what happens when the borrower defaults on the loan and prepayment details, should also be included.
Collateral May be Required
Collateral is any asset worth the loan amount used to secure the promissory note. It’s not required, but a lot of lenders will request it. Without collateral, lenders may charge a higher interest rate.
Consider Adding the Lender’s Signature
By default, the only signature needed is the borrower. It’s optional to include the lender’s signature.
Example of a Promissory Note
Download a free promissory note template below. You can choose to make it either secured or unsecured.
Promissory Note Frequently Asked Questions
Does a personal promissory note need to be notarized?
No. There’s no legal requirement for a promissory note to be notarized. However, you can get the note notarized if you choose to (and the other party agrees).
Can a promissory note be handwritten?
Yes, a promissory note can be handwritten. But it’s not recommended since adding or changing information with a handwritten note is easier.
Who signs a promissory note?
Typically, only the borrower signs a promissory note. Their signature is the only signature legally required, but the lender can also sign the note if they want.
Is a promissory note a contract?
Yes. A promissory note is a contract and is legally enforceable.