How Do Promissory Notes Work?
You’ve likely either had to lend money to or borrow money from someone or something. In many cases, these loans were informal arrangements between people you know, such as your friends or family. But in other cases, there were more formal agreements between you and financial institutions such as banks or credit unions. These loan agreements are often created via promissory notes.
A promissory note is a document that details a loan made between a lender (payee/promissee) and a borrower (payor/maker/issuer). Promissory notes contain the sum of money borrowed and the date the borrower will pay the money back. Sometimes, a promissory note is referred to as a note payable or even just a note.
There are several types of promissory notes, and while they are legal, promissory notes are often short and simple documents. They will mention repayment terms that have been mutually agreed upon by both parties. The document would also include interest rates if the lender wanted to be compensated for the loan.
What is a Promissory Note Used For?
The most common situations in which a promissory note is used are mortgages, student loans, car loans, business loans, and informal loans between family and friends.
However, a promissory note is just one way to stipulate the terms of a loan repayment plan so that you’re legally protected. If you’re lending money to friends and/or relatives, you might prefer to use an IOU.
An IOU differs from a promissory note because it’s simpler and only requires the borrower’s signature to make it legal.
If the loan is for a substantial amount and the involved parties don’t have a history with each other, you’re better off using a loan agreement rather than a promissory note. It will outline stricter guidelines and usually stipulate some security (e.g., a house as collateral).
Using Promissory Notes with Friends and Family
Loans between friends and family members are typically informal, but it’s always a good idea to have a written agreement between parties. A contract keeps the lender and borrower accountable if the court gets involved. So when writing your promissory note, make sure to do the following:
Include the right terms
You can use promissory notes for personal loans, but they should include terms both parties agree to and follow like any legal contract. In the case of a loan, they should have:
A Repayment Schedule
The note can require periodic payments where the borrowed amount is split over some time. The borrower can make repayments monthly, quarterly, or on any other schedule that suits both parties.
Alternatively, the note could state that the borrowed amount should be paid in full by a specific date or upon the lender’s demand. Payments of the total amount are called lump-sum payments, and these kinds of schedules are often used between people with close relationships, such as family members. There can be great flexibility in these agreements that can benefit the borrower.
Interest Rates if Applicable
If you’d like to be compensated for the loan, you should include an interest rate that satisfies you and the borrower. Remember that there are rules about how much interest you can charge someone.
There is a minimum interest rate called the applicable federal rate (AFR), which applies to loans above $10,000. The rates can change month to month, so it’s a good idea to check the IRS website about the rates you should charge when lending a significant amount of money.
There is also a maximum interest rate called the usury rate, which varies state by state. For example, the usury rate for New York is 6% per annum. You should check your government’s website to ensure you’re not breaking any laws.
Consequences for Nonpayment
When writing your promissory note, you should include terms describing what would happen if the borrower cannot pay you back. The consequences are entirely up to you as a lender. However, they must be within the limits of the law. For example, you cannot charge excessively high-interest rates or use illegal debt collection practices.
Typical consequences could be having collateral. This type of loan is referred to as a secured promissory note. The loan becomes secured when a specific property is attached as collateral.
If the borrower defaults, the lender can take the property from the borrower as a form of repayment. This kind of arrangement is often beneficial for the lender.
The opposite of a secured note is an unsecured promissory note. No collateral is used to secure the loan, but as the note is a legal contract, the lender has the right to sue the borrower and settle the loan in court. Unsecured notes are generally better for the borrower as they may not have many assets they can afford to use as collateral.
Remember the tax implications
When loaning money to someone, you should be aware that there can be tax consequences if you don’t follow specific guidelines.
- The IRS will consider the interest charged on loan as taxable income, so you are liable to pay tax on it.
- The applicable federal rate isn’t mandatory, but the IRS will tax you’re imputed interest’ if you charge a below-market interest rate on a loan. In other words, you will have to pay tax based on what the interest rate should be.
- The IRS will consider the loan a gift if you lend money without expecting repayment. You will then have to file a gift tax return depending on the loan amount.
If you’re unsure about the tax implications in your particular state, hire a qualified tax professional to help you.
Using Promissory Notes in Real Estate
You can use promissory notes in situations involving real estate. You can write them when you want a loan on the house or purchase real estate property.
Mortgage Promissory Notes
You can use a promissory note when borrowing money to buy a house. The lender will create a promissory mortgage note for you to sign. It’s not that different from a standard note, but it’s more formal and with more terms to be aware of.
Put simply, the mortgage note is an ‘IOU’ from the borrower to the lender. It states that the borrower will repay the loan amount described in the repayment schedule.
As for the consequences for nonpayment, those particular terms are always mentioned in the mortgage contract (i.e., the loan document) and sometimes on the promissory note. So when you’re getting a home loan, you will get a mortgage note and a mortgage contract, and those two documents will contain all the details and terms necessary for the borrower to repay the lender.
After you’ve paid off the mortgage loan, the lender will release you from the promissory note, and you are no longer bound to its terms.
Using Promissory Notes in Business
You can use promissory notes in various ways in the business world. But it’s commonly used for financing when you want to start or expand a business. There are two types of promissory notes in business; which one you use depends on your circumstances and your business type.
Personal Promissory Note
When starting a business, you will need funds to finance it. Different options are available, such as self-funding, crowdfunding, or even equity-funding. But depending on your circumstances, those options may not be that suitable.
In this case, you can try to get a loan from friends or family to fund the business and use a promissory note to document the loan terms. The loan would be going directly to you and not your business. So if your new business doesn’t work out, you would still be liable for the loan repayment.
Business Promissory Note
You can create promissory notes in your company’s name if your business is incorporated. This benefits protecting your assets from the business’s liabilities and obligations. So if you default on the loan, you can file the company for bankruptcy and avoid repaying the debt.
Business Loan Agreement vs. Promissory Notes
In the business world, you can get a business loan agreement or a promissory note. At their core, loan agreements are made between a lender and a borrower. The significant difference between them is that a promissory note may not include as many terms as a business loan agreement.
For instance, a promissory note may contain details about a loan and the repayment schedule. But a business loan agreement would also have terms detailing consequences for the borrower defaulting on the loan.
The lender typically keeps the promissory note in their possession until the borrower repays the debt. Once reimbursed, they cancel the promissory note and return it to the borrower.
Selling or Transferring your Promissory Note
Promissory notes have the capability of being sold and transferred. The lender can decide to sell their promissory note to a buyer for a quick payment. The party who bought the note purchases it for less than the value of the debt, which means they would have a profit when the loan is repaid.
The selling of promissory notes can happen in many situations, especially in real estate. Mortgage and real estate investors can buy mortgage notes through brokerages or bundles.
Your permission isn’t needed to sell your mortgage note, so they may not notify you of the transaction. If you notice a change in who accepts your repayments, you should double-check your promissory note to make sure the person is who they say they are and it’s not a fraud case.
You can still transfer promissory notes to another person outside the real estate. They would be able to assume the rights of the original lender, and the borrower would have to repay them to continue fulfilling the terms of the loan agreement. If you are the borrower and would not like the promissory note to be transferable, the note must explicitly say so in the terms.
What to Consider Before Signing a Promissory Note
A signed promissory note outlines the transaction’s terms and conditions, so all parties can be assured that their deal and intentions are entirely recorded.
Review the promissory note before you sign it or exchange any money. You should consult a lawyer if substantial sums are involved or any complex details.
Promissory Note Frequently Asked Questions
What makes a promissory note invalid?
There are several instances where a promissory note could be made null and void:
- The promissory note hasn’t been signed – For the loan agreement to be a legally binding contract, it must include the signatures of the lender and the borrower.
- There are unclear terms in the note – You need to make sure that the clauses mentioned in the document are clear and use the correct legal language. You can download our promissory note template to get you started if you’re unsure.
- The terms in the note are illegal – Your promissory note must respect fair lending practices. That means the interest rate cannot break your state’s usury laws.
- The original promissory note has been lost – When creating the note, the lender keeps the original, and the borrower keeps a copy. But if the original is lost, then it isn’t easy to prove there was a loan agreement in the first place.
- The promissory note has been altered without permission – Both parties must agree to the terms in the loan agreement. But if one party made alterations without the other party’s permission, the note is rendered invalid.
How enforceable is a promissory note?
Once both parties have signed a promissory note, it is a legally binding contract that the court can enforce.
If the lender is a traditional lender such as a bank, they will enforce the promissory note by foreclosure. Before you sign a promissory note, make sure you can make the necessary payments.
You should also keep records of the payments you’ve made to the lender as evidence that you’ve complied with the agreement’s terms and conditions. If you’re being accused of doing otherwise, you can easily present proof of your payments to the court.
How do you enforce a promissory note?
It’s difficult to enforce a promissory note. It can be a long and complex process, but if the promissory note is secured (includes collateral), the lender has the legal right to take the collateral specified in the note (e.g., a house).
You can either repossess the property yourself or hire a debt collection agency to do so. While a collection agency has a fee, they are usually more successful in their efforts.
If you have an unsecured promissory note, the best approach is to speak to the borrower first and reach a reasonable agreement. Otherwise, you’ll need to draft a demand for payment letter.
You may have to seek a court judgment if the borrower isn’t cooperating with the terms of the agreement. The judge could then decide on a course of action for the borrower to repay you. For example, garnishing the borrower’s wages until the debt has been satisfied.