A promissory note can simply be defined as a written promise to pay someone. There are several types of promissory notes, and you’ve almost certainly signed one if you’ve ever taken out a loan.
A promissory note contains the terms of the agreement, including the:
- name of the lender
- name of the borrower
- amount borrowed
- frequency and size of repayments
- interest rate
- description of any collateral
- date and place the promissory note was issued
- borrower’s signature
Types of Promissory Notes
Here are seven of the most common types of promissory notes:
- Simple promissory note — This note acts as a written guarantee that a loan will be repaid as agreed. The purpose of the loan does not need to be specified.
- Student loan promissory note — Officially known as a master promissory note, this is an agreement to pay back a loan for education, with interest.
- Real estate promissory note — This note includes a promise that the borrower’s property can be used as collateral if the loan is not repaid according to the terms.
- Personal promissory note — A personal promissory note documents a loan between friends or relatives.
- Vehicle promissory note — A note that sets out payments the borrower will make to a lender in exchange for a vehicle.
- Commercial promissory note — This note is used when borrowing money from a commercial lender, and may specify full repayment of the loan (including interest) if the borrower misses payments. This means the lender can immediately take possession of any property put up as collateral.
- Investment promissory note — This type of promissory note is often used instead of a business loan to raise capital for a business — offering the investor a return on their investment over a specified period.
What is a Promissory Note Used For?
The most common situations in which a promissory note is used for 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 instead.
An IOU differs from a promissory note in that 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 kind of security (e.g., a house as collateral).
What to Consider Before Signing a Promissory Note
A signed promissory note completely outlines the terms and conditions of the transaction, so all parties can be assured that their deal and their intentions are completely recorded.
Be sure to review the promissory note before you sign it or exchange any money. If there are substantial sums involved or any complex details, you should consult a lawyer.
Remember, certain state usury laws place a cap on interest rates to one that reflects fair market value. Another consideration is taxation: The IRS taxes interest earned by lenders, and if no interest rate has been set, the IRS may impose its own rate.
If you’re unsure about the tax implications in your particular state, hire a qualified tax professional to help you.
Enforcing a Promissory Note
If the borrower fails to repay the lender according to the agreement’s terms, the promissory note will need to be enforced. This may happen if the borrower doesn’t follow the repayment schedule set out by the promissory note or hasn’t repaid the loan by its maturity date.
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), then the lender has the legal right to take the collateral specified in the note (e.g., a house).
If the promissory note in question is an unsecured promissory note, its enforcement procedure is considerably more difficult. The lender cannot recover any collateral if the borrower falls behind on repayment, so they must pursue alternative routes.
The best approach is to speak to the borrower first and try to come to a reasonable agreement. Otherwise, you’ll need to draft a demand for payment letter.
After that, you’ll need to hire an approved, professional collection agency to recover the debt. If that fails, you’ll have to file a petition in court to enforce the promissory note.
What Invalidates a Promissory Note?
In certain circumstances, your promissory note may not be legally valid, which means that neither party is bound by its terms. This can be particularly serious for the lender if the note covers a substantial sum of money.
Here are some of the reasons a promissory note may be deemed invalid:
- The borrower did not sign it
- The original promissory note has been altered
- The note wasn’t correctly written in the first place
- The lender has no right to claim the debt
- You can’t locate the note or prove it ever existed
- It violates state law (charging an illegally high rate of interest, for instance)
Promissory notes are a useful and relatively simple tool for protecting yourself financially if you plan on borrowing or lending money. However, you need to ensure that the terms of your promissory note meet all legal requirements, and provide adequate safeguards should either party fail to comply with its terms.