Promissory notes are legal documents used in real estate transactions to establish the terms and conditions of a loan for real estate property. They formalize the borrower’s promise to repay the real estate loan within the terms provided.
Understanding how they work in real estate transactions can help borrowers and lenders protect their legal interests and avoid unnecessary complications.
What Is a Promissory Note In Real Estate?
A promissory note in real estate acts as a legally binding agreement between the lender and borrower. It typically includes the loan amount, details about repayment, and consequences in the event of default.
Real estate loans generally include a promissory note or loan agreement and a mortgage or deed of trust.
The primary difference between a promissory note, a mortgage, or other real estate financial instrument is its intent. A mortgage or deed of trust enforces a promissory note, establishing consequences for non-payment by using the property as collateral for the loan. If the borrower defaults on the loan agreement, the lender can use the mortgage or deed of trust to take possession of the property and sell it to recover the loan value.
Once the loan is satisfied, the lender provides a release, and the property belongs to the borrower, free and unencumbered.
Types of Promissory Notes in Real Estate
There are four primary types of promissory notes in real estate. They may be secured or unsecured and have adjustable or fixed-rate interest.
Secured vs. Unsecured Notes
The primary difference between secured and unsecured promissory notes is collateral.
Secured: Use collateral, often the property itself, to ensure payment by the borrower. The lender takes possession if the borrower fails to meet the note terms. The lender may also accept different property, such as a vehicle, as collateral instead.
Unsecured: Does not use collateral to ensure loan repayment. Should the buyer default, the lender may pursue collections or sue the buyer to recover the property value.
Adjustable Rate vs. Fixed-Rate Notes
Adjustable rate and fixed rate notes apply different interest rate terms.
Adjustable rate: Allows for changes to the interest rate and monthly payment. Adjustable rates are ideal for real estate transactions when the buyer expects to pay the loan off or sell before the interest rate increases.
Fixed-rate: Establishes a set interest rate and monthly payment amount. This reduces the risk for the buyer, who can make a repayment plan without unanticipated changes.
Components of a Real Estate Promissory Note
Each real estate promissory note has different details based on your transaction, but most include the following:
- Principal amount: Indicates the amount of the loan and the currency in which it is calculated. This is usually the value of the real estate property being purchased.
- Interest rate: Specifies the fixed or adjustable interest rate the borrower agrees to pay to the lender over the term of the loan
- Maturity date: Indicates the agreed date for the loan to be paid in full. This is usually the final installment due date.
- Payment schedule: Defines the frequency and amount of installment payments to pay the promised loan amount by maturity.
- Security clauses: Details the property used as collateral for secured notes and the penalties and legal actions the lender may take in the event of default.
Review your state requirements before signing to avoid invalidating the promissory note.
Types of Real Estate Financing Supported by Promissory Notes
Promissory notes are often part of a larger real estate financing plan. The most common uses in real estate include the following.
1. Traditional Mortgages
Most traditional mortgages include a secured note. The note acknowledges that the borrower is responsible for repaying the loan from a bank or lending institution. It consists of the amount and terms of repayment and, with the mortgage agreement, outlines the penalties for default.
Usually, a traditional mortgage allows the lender to take ownership of the financed property if the borrower fails to meet the payment terms agreed to in the note.
2. Seller Financing
Sometimes, the seller of a property may not choose to go through a bank or lending institution. Instead, they will finance the purchase directly through seller financing. Seller financing allows the seller to receive payment for the real estate property directly from the buyer.
A clear, detailed promissory note is critical for seller financing. It is the primary payment agreement between the buyer and seller and should include loan terms, payment amounts, and interest rates. A promissory note for seller financing should address the penalties and remedies for late payments and non-payment.
3. Private Loans
When purchasing real estate, the buyer may not use a mortgage but instead opt for a private loan. This could be through a banking institution or other lender. As with other real estate purchase options, a promissory note ensures both parties know the loan repayment amounts, terms, and interest rates.
Private loans for real estate often arise when the real estate value is too low for a traditional mortgage, or the buyer does not have sufficient assets or credit to qualify for a mortgage.
Importance for Buyers and Sellers
Promissory notes provide critical legal documentation that benefits lenders and borrowers in real estate transactions.
Advantages for borrowers include:
- Clear repayment terms
- Documented interest rates
- Protection from changes to payment terms
- Greater financing flexibility
- Reduced closing costs
- More control over loan terms
Advantages for lenders include:
- Documents loan details
- Legally binding and enforceable
- Protection from default
- Fewer restrictions
- Higher interest rates
- Faster repayment terms
How Do Promissory Notes Work In Real Estate?
Promissory notes facilitate real estate purchases and home loans by promising the lender payment on specific terms. The note establishes a legally binding contract between a borrower and lender for repayment. They are often incorporated into real estate transactions when the borrower does not qualify for a traditional mortgage loan through a lending institution.
They detail the loan agreement, including the principal, repayment amount, and interest. A promissory note may be used with a mortgage, deed of trust, or loan agreement. The lender and the borrower sign to make it a legally binding agreement.
Unlike a mortgage or deed of trust, the note does not necessarily allow the lender to take possession of the property or other named collateral in the event of default. Unless otherwise specified, it does not typically allow the lender to foreclose on the property to recover their investment. Instead, the lender can sue the defaulting borrower to recoup the loan value.
Legal Implications and Protections
Whether you are a borrower or lender, you benefit from understanding the legal implications, protections, and state-specific laws governing promissory notes before signing a real estate loan.
Since a promissory note is a legal and binding agreement, it offers some protection for both the lender and the borrower. A signed, documented payment agreement allows both parties to hold the other accountable if there is a disagreement.
A promissory note can ensure the buyer takes ownership of the property when they satisfy the loan agreement terms. At the same time, the note provides guidelines for loan repayment and outlines consequences. This protects the lender, who has legal grounds to sue the borrower if they default.
Forfeiture Clauses and Enforceability
Promissory notes in real estate transactions present a greater risk for the lender, especially when they are unsecured by a mortgage or other security instrument. Even if they sue for non-payment, the lender could lose financially if the borrower defaults and has no assets to cover the loan value. They may mitigate this loss by requesting a higher down payment or negotiating a higher interest rate.
Some lenders try to protect themselves by establishing a forfeiture clause. In the event of default, a forfeiture clause allows the lender to retain the property and any payments made on the promissory note up to that point. Many states will not uphold a forfeiture clause.
Steps To Use a Promissory Note For Home Purchase
- Agree on terms: The borrower and lender agree on the loan amount, payment amounts, installment frequency, and maturity date.
- Draft the note: Start with a fillable promissory note template. Fill out the details and sign.
- Secure the note with a mortgage or deed of trust: If your note is secured, attach a mortgage, deed of trust, or other security instrument to outline terms and remedies in case of default.
- Close the sale: Pay all fees, clear escrow funds, and sign documents to transfer property ownership.
- Repayment: The borrower repays the real estate loan in installments as specified in the promissory note.
Considerations
- Legal and tax implications: Not only does a note establish a legal obligation for the borrower, but the lender must also pay taxes on any interest they receive from payments.
- Default risk: The lender should consider the possibility that the borrower will fail to repay the loan as agreed, called default risk.
- Record keeping: It is wise to record the note and all other documentation related to the real estate loan and transfer of ownership, even after the loan is repaid. Some states also require certain real estate documents to be filed with local authorities.
- Professional advice: If you have no experience with real estate transfers, promissory notes, or lending, you may benefit from working with a seasoned professional who can help protect your legal rights.
