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Complete Guide to Promissory Notes

What Promissory Notes Are & How They Work
Lauren Ward

Lauren Ward

Updated December 27, 2021
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Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.
Much as its name suggests, a promissory note comes with a promise that the issuer will repay the amount owed. It’s essentially a formal IOU that’s legally binding should the borrower not make payments.

What Is a Promissory Note? 

Promissory note definition: A legal document that a borrower signs promising to repay a loan within a certain time frame. Loans and promissory notes often go hand in hand. If you’ve ever taken out a loan, you’ve very likely signed a promissory note (or its close cousin, a loan agreement). Anyone lending money can require a promissory note. Should one friend lend money to another friend, for example, he or she could get that person to sign a promissory note — it’s not just limited to the official lending world. A promissory note is actually a great idea if one friend lends the other money because it shows respect and commitment. And, if they ever have to go to court, it makes the judge’s decision a simple one. 

What Is a Debt Covenant?

A debt covenant and a promissory note are sometimes mistaken for each other. A debt covenant states what the borrower can and cannot do in order to take out a loan. The restrictions lenders sometimes place on borrowers include taking out more debt, selling certain assets, and paying out large amounts in cash dividends. Debt covenants do not outline things like interest rates, monthly payments, or loan amounts, which are left for promissory notes or loan agreements. 

How Promissory Notes Work

A promissory note doesn’t do anything except hold the borrower legally accountable for any money he or she borrows from the lender. It lays out the loan terms and includes the borrower’s signature. From that point on, the borrower must make all payments as agreed, or the lender is entitled to take legal action.  What Is in a Promissory Note?Learning how to write a promissory note is easy. If it’s a simple agreement between the two parties, you only need the following information:
  1. Name, address, and phone number of the lender
  2. Name, address, and phone number of the borrower
  3. Total amount of the loan
  4. Total amount of interest, if there is any
  5. List of any collateral being used to secure the loan that the borrower agrees may be seized if payments are not made
  6. How often the borrower is expected to make payments toward the loan
  7. Total amount of each payment
  8. Signature of both the lender and the borrower
Promissory note example: Your friend’s car needs a new transmission. To replace it, the mechanic gave him a quote of $4,000. He has bad credit and doesn’t have enough savings to pay for the repair work. You say he can borrow the amount from you, but that you expect it to be paid back in regular monthly installments. He agrees, and the two of you sign a promissory note to make the agreement legally binding. 

Pros and Cons of Promissory Notes

As with anything, there are both pros and cons when using a promissory note.
There are two primary types of promissory notes you can use.

Investment Promissory Notes

Investment promissory notes must often be notarized or registered to minimize risk. Most of the time, they’re offered to seasoned investors able to handle default. Sometimes investors who buy investment promissory notes even sell them to other investors. These types of notes often sell for a large discount, and sometimes they are only partially sold to other investors. When this happens, the investor is buying the right to a predetermined amount of payments. Investors who need to quickly raise capital themselves may do this. Usually the general public is not allowed to take part in these types of transactions. 

Corporate Promissory Notes 

In the business world, companies often use promissory notes as a means of fast, short-term financing. An example would be a company that has quickly sold out of all available stock or inventory but has yet to receive any money from customers. If it owes money to creditors, the company may ask those creditors to accept a promissory note as a means of payment. The promissory note will be exchanged for cash once payment is received. Promissory notes are also used by companies that have run out of other options with loans or bonds. However, anyone thinking of buying notes from such companies should be aware that these types of loans are at a greater risk of default. Still, the interest rate is pretty high, which means there’s a possibility of a high return for investors.Often corporate credit promissory notes must be registered with the state or the Securities and Exchange Commission (SEC). If a regulator hasn’t reviewed it, it’s up to the investor to do his or her own homework to ensure the borrower is actually capable of paying back the money. If they default, there is often little to no recourse.  

Collecting on Promissory Notes 

Anytime a lender lends money to a borrower and a promissory note is used, the plan is for the borrower to make payments as outlined in the note. However, sometimes that doesn’t happen. Before anything extreme, first send a written letter after 30 days has elapsed. Send another at 60 days, and one more at 90 days if they have yet to respond. If possible, call the borrower and find out what is happening. Ask them if they could at least make a partial payment. Or offer to rewrite the loan terms to allow for a lower monthly payment? If none of these steps work, another option is to try using a debt collector. The debt collector will work on your behalf to reclaim your money in exchange for a percentage of the debt. You could also simply sell the debt to someone else, where they would then owe the full amount of the debt. The last option is to sue the borrower for the full amount. With the promissory note in hand, the judge will likely rule in your favor.  

Promissory Notes vs. Mortgages 

When you buy a house, you sign a promissory note (or mortgage note) with the lender that outlines the terms of the loan. However, a promissory note can also be used as a means to help people who normally wouldn’t qualify to buy a home. An example of this would be owner financing. In owner financing, the buyer pays the seller directly instead of working through a lender.   

Promissory Notes vs. Loan Agreements

Promissory notes and loan agreements are essentially the same thing; however, loan agreements are often the preferred document when complex issues such as collateral, interest, and late payment fees are included. Because of this, large banks and lending institutions often use loan agreements instead of promissory notes.

How Investing in Promissory Notes Works 

To avoid scams, the promissory note should be registered with the SEC or a state securities regulator. Sometimes they are exempt, but those are special circumstances and are rarely the case. Any seller offering the sale of a promissory note must be licensed to do so. You should check his or her registration status at IAPD before moving forward.Generally speaking, the promissory note should have a similar return rate as other investments. If it’s much higher, then it may be a scam.

Sample Promissory Note

$________Date: ________________, 20_____For amount received,__________________, the borrower, at _____________________ (address), promises to pay __________________, the noteholder, at _____________________ (address), the principal amount of $_________, with interest at an an annual rate of _________ percent on any balance. Monthly payments shall be made on the  _________ of each month. In the event the borrower fails to make payments for ________ days after payment date, the borrower will be responsible for all costs associated with collection, including attorney fees and court costs. Signature of Borrower: ________________________Printed name of Borrower: ________________________

The Takeaway

When you are lending money, promissory notes are essential documents. Learning the ins and outs will help you through the process.While a promissory note may seem like the only path to financing for some individuals or companies, there are lenders on the market willing to work with borrowers of many credit profiles. Lantern helps small businesses find the lending they need by matching them up with lenders who want to work with them. They can even help you find business acquisition loans.Both applying for business loans and comparing small business loans is possible with one simple form.
Photo credit: iStock/Paul Bradbury
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About the Author

Lauren Ward

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.
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