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If you ever take out a loan for yourself or your business, you may need to sign a promissory note. A promissory note is a document that spells out your promise to repay the loan. Financial institutions sometimes use promissory notes instead of more formal loan agreements. Promissory notes are also commonly used for loans between people who have an informal relationship, such as friends or family members. Though promissory notes are shorter and less structured than standard loan agreements, they are legally binding and include much of the same basic information. Exactly what is included will depend on the type of promissory note.Here’s what you need to know about common types of promissory notes, how they work, and when you would want to use one.
What Is a Promissory Note?
A promissory note is a written promise to pay back a loan, usually within a specific time period. It’s more formal than an IOU scribbled on a napkin, but not as long and detailed as a standard loan agreement. A promissory note establishes a clear record of a loan, either between individuals or between entities. A promissory note may be used by two private individuals, by a commercial lender when making a loan to an individual, or between an individual and their business, such as when a business owner makes a loan to his own LLC. At a minimum, a promissory note will identify both parties, detail the loan’s sum, and lay out the time period in which the borrower promises to pay the money back. By putting all the key details of the loan in writing, a promissory note ensures clarity on due dates for payments and the amount of payments.
How Do Promissory Notes Work?
Any two parties who wish to enter into a loan agreement can write a promissory note. As long as the document is labeled a “promissory note” and has been drafted properly, it will be legally binding and enforceable. The document should identify both parties, explicitly stating the borrower is going to repay any amount borrowed, outline the terms and conditions of the loan, and be signed by both parties. A promissory note will often include:
Loan principal
Interest rate
Beginning date (when the loan will be disbursed)
Payment dates (this could monthly or just a single payment date when the entire loan is paid back)
Payment amount(s)
Loan maturity date (when loan should be paid in full)
Collateral (or any type of lien, such as a blanket lien)
Signatures of both parties
8 Types of Promissory Notes
Below are eight types of promissory notes you may consider using.
1. Commercial Promissory Notes
This is a formal type of promissory note that may be used by a commercial lender, such as a bank or credit union, when issuing a loan to a private individual. A commercial promissory note can be used for auto loans, personal loans, and different types of business loans. A commercial promissory note will detail the specific terms agreed between the borrower and lender, including any collateral put up for the loan, late fees, and consequences of defaulting on the loan.
2. Real Estate Promissory Notes
A real estate promissory note may be used by a bank when issuing a home mortgage to a borrower. It is also commonly used when a private individual is loaning a friend or family member money to purchase a home. A real estate promissory note will indicate that the home is collateral for the loan, and the creditor or issuer can theoretically place a lien on the property if the borrower cannot pay by a specific date or defaults on the loan. If the lender is a financial institution, the missed payments are reported to the three credit bureaus, which will likely result in a negative mark on the borrower's credit report.
3. Informal Promissory Notes
Informal promissory notes are often written between friends and family members. This type of note is a legal acknowledgement between two parties that there is a debt between them, how much was loaned, and by what date the money will be paid back. There may not be as much detail about repayment terms or purpose for the loan as there is in a more formal promissory note, but there is a guarantee from the borrower that the loan will be repaid.
4. Student Loan Promissory Notes
When a student takes out a loan from a federal or private lender to pay for undergraduate or graduate schooling, they often sign a student loan promissory note. For federal student loans, this type of note is often called a master promissory note. A student loan promissory note is an agreement between a lender and student borrower that any and all funds borrowed are to be used for educational purposes only and will be repaid with interest according to a specific repayment schedule. It may also include any late fees you may have to pay, as well as forbearance, deferment, and cancellation options.Sometimes children and parents will write a student loan promissory note, where the child promises to repay back any money he or she borrowed while in school.
5. Vehicle Promissory Notes
A vehicle promissory note is an agreement that a borrower will make payments to a lender in exchange for a car. It will typically include information about the make and model of the vehicle, certification that the vehicle owner has the right to sell it, an odometer statement, if the vehicle’s title will be transferred to the borrower once the loan is paid, and what defaulting and missed payment penalties will be.Car promissory notes are not necessary for transferring ownership of a car when no money is exchanged. In these situations, many states simply require the transfer of ownership to be recorded on the car’s title.
6. Personal Loan Promissory Notes
A personal loan promissory note is another name for an informal promissory note, which means it is a legal contract between friends or family members where one party has borrowed money from the other. Often there is no stated purpose for the loan but, as with all promissory notes, it will outline how much debt exists between both parties, and state that the debt must be repaid and by what date.While it can be tempting to forgo any documentation for a loan between friends or family members, having a personal loan promissory note can head off any unforeseen disagreements.
7. Simple Promissory Notes
A simple promissory note is often used when the lender and borrower are family members or friends and the loan will be repaid in one lump sum, rather than according to a payment schedule. For example, if you loan your sister $1,500 and she agrees to pay the whole amount back to you by December 1, you might write up a simple promissory note including those details. You may or may not decide to charge interest. If you do, you can include it in the promissory note.
8. Investment Promissory Notes
An investment promissory note can be used to raise capital for a business in lieu of applying for a small business loan. A small business might use this type of note when someone is willing to invest money into their company, but expects that money to be paid back. Having a promissory note stating that the business will repay the money alleviates some of the risk for the investor. An investment promissory note is debt as opposed to equity. The business owner still owns as much of their company as they did prior to the promissory note. However, if the owner fails to pay back the money, the investor is legally allowed some ownership of the company.
Promissory Note Repayment Option Types
Promissory notes can spell out different repayment options. Here are the four most common ways for a borrower to repay money and interest to a lender.
1. Installment Payments
Installment payments are often used on promissory notes for large loan amounts that would be difficult to repay in a few payments, such as when someone is financing the purchase of a car, boat, or appliance. With an installment payment plan, payments are broken up into equal monthly payments that include both principal and interest. Payments continue until the loan principal is completely repaid. To reduce the amount of interest paid on an installment loan, borrowers can often make a down payment on the loan. Recommended: What Are Installment Loans?
2. Due on Demand
Also called “pay when you can,” a due on demand repayment option is often used on promissory notes between family and friends. With this set-up, there isn’t an established payment schedule or repayment due date. The borrower can pay the money back when they are financially stable. Because of the lack of structure, due on demand promissory notes are generally best suited for small loans between people that trust each other. If a promissory note does not have any payment terms, it’ll be considered a due on demand note.
3. Due at a Specific Time
With a due on a specific date payment plan for promissory notes, the borrower and the lender must agree on a specific date the loan (including any interest) is expected to be repaid in full. With this method, there aren’t any established monthly payments. The borrower is simply expected to have the loan paid off by a certain date. They can choose to make monthly payments, but it is not required. This can work well on loans for small amounts of money.
4. Balloon Payments
A balloon payment is a large payment that is due at the end of a loan term. Promissory notes that have balloon payment specifications will usually have smaller monthly installment payments before the final balloon payment. This repayment option is commonly used in mortgage loans, where the interest rate is low, but after several years the borrower must either make a balloon payment (if they can afford to) or reset the loan at a higher interest rate.
Small Business Loan Rates
If you’re looking for capital for your business, a promissory note may come into play. You might use an investment promissory note to encourage people to invest in your company with the promise that you will repay the funds. If you are seeking a business loan from an established lender, you might sign a commercial promissory note with an installment payment schedule. If you’re interested in finding out what type of small business loan your company might qualify for, Lantern by SoFi can help. With our simple online lending platform, you can receive an offer from one of the top small business lenders in our network, all with just one application and no obligation to you.
Frequently Asked Questions
What type of contract is a promissory note?
Is a promissory note a type of loan?
How binding are promissory notes?
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About the Author
Lauren Ward
Lauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.
