If you’re borrowing or lending money, it’s important to select the right type of promissory note to reflect the terms of the agreement. Your note should detail the reason for the loan (personal, business, real estate, etc.) as well as the terms of the repayment schedule.
What is a Promissory Note?
A promissory note is a document used to create a legally-binding agreement that a borrower will repay a lender a determined sum of money and interest. The frequency, amount, and payment schedule depends on the type of promissory note used, and the agreed upon repayment option.
Types of Promissory Notes
Select the type of promissory note that best represents why both parties agreed to the loan.
1. Simple Promissory Note
A simple promissory note is used to create a written guarantee that money borrowed will be returned to the lender in an agreed-upon manner. Unlike the promissory notes described below, the purpose of the loan doesn’t need to be detailed.
2. Student Loan Promissory Note
A student loan promissory note, referred to as a master promissory note by the government, is an agreement that a borrower will repay their loans used for education purposes — including the interest charged.
Although student loan promissory notes are primarily between a borrower and the government, some students create promissory notes with their parents or other relatives who pay for their education.
3. Real Estate Promissory Note
Similar to a commercial promissory note, a borrower uses their property as collateral to secure a real estate promissory note. If a borrower defaults on it, the lender can place a lien on the property. If this occurs, the information can become public record and affect the borrower’s credit.
4. Personal Loan Promissory Notes
A personal promissory note is used to document a loan between friends or family members. It can be tempting to forego formal documents when lending money to loved ones. But regardless of how well you know someone, having a written record of the loan can help unforeseen disagreements.
5. Car Promissory Note
A vehicle promissory note creates an agreement that a borrower will make payments to a lender in exchange for a car. The note should include details about the make and model of the vehicle, and be kept somewhere accessible in the event ownership of the car needs to be proved.
6. Commercial Promissory note
A commercial promissory note is used when borrowing money from a commercial lender such as a bank or loan agency. In the event the borrower is unable to make required payments, the lender may demand full payment of the loan – including interest. Furthermore, the lender is entitled to assign a lien on assets owned by the borrower until payment is received.
7. Investment Promissory Note
An investment promissory note, often a substitute to a business loan, is used to raise capital for businesses. Investment notes reduce the risk of investing in a business by ensuring the investor receives a return on their investment over a given period of time. If the borrower fails to pay the money, the investor is legally able to take ownership of the company.
Types of Promissory Note Repayment Options
Typically, there are four ways for a borrower to repay money and interest to a lender.
1. Installment Payments
Installment payments are frequently used to buy expensive items like cars, boats, and appliances. Usually, the payments are made in equal monthly amounts, including interest, until the principal balance (the total amount borrowed) has been repaid.
Borrowers can place a down payment on the installment loan to reduce the total amount of interest paid, if they can afford to do so.
2. Installment Payments with a Final Balloon Payment
Balloon payments are frequently used in mortgage loans, and typically used by short-term borrowers because they feature lower interest rates than long-term loans.
In a balloon payment, the borrower agrees to pay a low interest rate for a period of time, for example five years, and pays back only a fraction of the principal balance in that time.
At the end of the term, the borrower has the option to reset the loan (potentially at a higher interest rate) or pay off the massive remaining balance (the balloon), if they can afford it.
3. Due on a Specific Date
For smaller loan amounts, borrowers and lenders can agree to a specific payback date. Lenders will know exactly when they’ll be paid back, and borrowers will not have to worry about monthly payments. Instead, the borrower repays the entire amount of the loan — the principal plus any interest — on a specific date.
4. Due on Demand
Due on demand notes are usually used for loans between family and friends. As there are no specific payment terms, these loans are sometimes called open-ended loans.
Borrowers can pay back the note when they’re financially stable, and lenders can be assured they’ll have an income source if necessary. If a note does not have any payment terms, it’ll be considered a due on demand note.
Failing to outline payment amounts and schedules can cause confusion, unmet expectations, strained relationships, and even legal action to be taken.
Make sure both parties agree to one of the following four repayment options before signing a promissory note.