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A promissory note is a written promise that you will pay back money owed within a certain amount of time. It’s essentially a formal IOU that’s legally binding should the borrower not make payments as promised.Though banks and other financial institutions will sometimes issue a promissory note, they are most commonly used when borrowing money from a source other than a bank, such as an individual or a company. Essentially, a promissory note allows anyone to become a lender. Here’s what you need to know about promissory notes, including how they work, how to write one, and when and why you might use one.
What Is a Promissory Note?
A promissory note is defined as 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, they could ask 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 it much easier for the judge to make a decision about who is owed what and by whom.
What Is a Debt Covenant?
A debt covenant is different from a promissory note. Debt covenants are restrictions that a lender may put into a promissory note or lending agreement stating what the borrower can and cannot do until the loan is repaid. These restrictions might include not being allowed to take out more debt or sell certain assets for the duration of the loan. Debt covenants do not outline things like interest rates, monthly payments, or loan amounts.
History of Promissory Notes
Promissory notes actually have a long and interesting history. There is evidence that they may have been used as far back as ancient times. They were also commonly used in renaissance Europe to help merchants buy and sell goods in other countries. In fact, promissory notes are considered to be the first form of paper money, since the person who received a promissory note could give it to someone else as a form of payment. These days, promissory notes are most commonly issued between individuals lending money to other individuals. Promissory notes are also sometimes used by banks and other lenders for mortgages, different types of small business loans, and other types of loans.
How Promissory Notes Work
A promissory note holds the borrower legally accountable for any money they borrow 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 to Include 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:
How often the borrower is expected to make payments toward the loan
Total amount of each payment
Signature of both the lender and the borrower
Promissory Note Example
Your friend’s Joe’s car needs a new transmission. To replace it, the mechanic gave him a quote of $4,000. Joe 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.
Promissory Note Repayment Terms
Promissory notes specify the repayment terms, which is exactly how the loan is to be repaid. The options include:
Lump Sum
This means the entire loan amount must be repaid in single payment.
Due on Demand
With this set-up, the borrower must repay the loan whenever the lender requests repayment.
Installment
This means the loan needs to be paid back in a series of scheduled installments, or payments.
With or Without Interest
The promissory note will specify whether the borrower will repay the loan with interest (and what the rate will be) or without interest.
Pros and Cons of Promissory Notes
Legally speaking, promissory notes fall somewhere between informal IOUs and rigid and complicated loan agreements written by corporate lawyers. As a result, they have both pros and cons. Here’s how they stack up.
Advantages of a Promissory Note
Disadvantages of a Promissory Note
Can be reassuring to a non-traditional lender that a borrower will pay back any money borrowed
Can give false sense of security for non-traditional lenders who don’t have tools of larger lenders
Easy to create and write up
In some states, if promissory note isn’t notarized, legal issues may arise
There are several different types of promissory notes. Which to use when depends on the type of loan involved and the information the note needs to contain.
Informal Promissory Note
This type of note is used when a loan is being made between family members or friends.
Commercial Promissory Notes
These notes are more formal and typically spell out all the specific conditions of a loan between a formal lender and a person or business.
Real Estate Promissory Notes
This type of promissory note may accompany a mortgage or other real estate purchase arrangement.
Investment Promissory Notes
This is a type of promissory note issued by a company to raise capital. Investing in promissory notes involves risk, which is why these notes are usually only offered to seasoned investors able to handle default, and not the general public. Often investors will buy investment promissory notes and then sell them to other investors.
Corporate Promissory Notes
Companies often use promissory notes as a means of short-term business financing. An example is a business that is waiting on money due from customers but currently doesn’t have the cash to pay its creditors. It might ask those creditors to accept a promissory note as a means of payment. The promissory note is then exchanged for cash once the business has received payment from its customers.Recommended: A Guide to Trade Credit in Business
When to Use Promissory Notes
If you are lending a large sum of money to an individual or business, then it can be a good idea to create a promissory note that the borrower will sign. This establishes a legal record of the loan and will help protect you and ensure that you get repaid. You may be asked to sign a promissory note when you take out a mortgage, student loan, car loan, small business loan, or small personal loan, or if you borrow money from a family member or friend.
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 have 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 own 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 take out a loan to buy a home you may be asked to sign two key documents — a mortgage and a promissory note.While home buyers often think of a mortgage as a loan, it’s actually the contract you sign with the lender to provide collateral for a loan. By signing the mortgage, you give the lender the right to sell the home should you fail to make payments on the loan. The promissory note is a separate contract that spells out the borrower's promise to repay the amount borrowed. The promissory note that accompanies a mortgage includes the loan terms, including the interest rate, the amount of the loan, the late charge amount, and the term (number of years). When you sign a promissory note, you are promising to repay the amount you are borrowing to buy the home, usually via monthly payments. Recommended: 28 Mortgage Terms, Explained
Promissory Note Tax Implications
If a buyer can’t qualify for financing to buy a home from a traditional lender, they may be able to get owner financing. In this setup, the buyer pays the seller directly instead of working through a lender. The terms of the loan are spelled out in the promissory note. However, before the note is created, the buyer may be able to negotiate the price of the home and interest rate on the loan at the same time.From a tax perspective, it can be better for a buyer to have a lower sales price and a higher interest rate, rather than vice versa. The reason is that you can typically write off the interest on the home loan when you file your taxes. And, after a year or so of making on-time payments, you may be able to refinance with a traditional lender at a lower interest rate.
Business Promissory Notes vs. Student Loan Promissory Notes
A business promissory note is a document that spells out your promise to repay a business loan. Financial institutions sometimes use them. However, business promissory notes are more commonly used when a new or young business is acquiring financing from an individual, such as a family member or friend. These promissory notes will typically contain all the details of the loan, including the principal amount, interest rate, and maturity date.Promissory notes also come up in the student loan world. Private lenders typically require students to sign promissory notes for each separate loan that they take out. With federal student loans, it’s often possible to sign one “master” promissory note for multiple federal student loans. Student loan promissory notes spell out the rights and responsibilities of student borrowers as well as the conditions and terms of the loan.
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.
Simple to write up?
Both borrower and lender must sign?
Good for small sums of money?
Good for large sums of money?
Promissory Note
Yes
No
Yes
No
Loan Agreement
No
Yes
No
Yes
How Investing in Promissory Notes Works
Sometimes a company will use an investment promissory note to raise money. Through the note, the company promises to return the buyer's funds (principal) and to make fixed interest payments to the buyer in exchange for borrowing the money. Promissory notes have set terms, or repayment periods, ranging from a few months to several years.By investing in promissory notes, you are effectively taking on the risk of a large bank but without the resources to minimize this risk by spreading it out over thousands of loans. That risk can translate into a large reward. However, it can lead to a major loss if the company is unable to carry out its promise to pay interest and principal to buyers of the note.
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, beginning on____________. 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. If not paid sooner, the entire remaining loan balance (including accrued interest) shall be due and payable on _________________,Signature of Borrower: ________________________Printed name of Borrower: ________________________
The Takeaway
A promissory note is a document that spells out your promise to repay a loan. While financial institutions sometimes use them, promissory notes are more common when a borrower is acquiring financing from an individual, such as a family member or friend. They typically contain all the details of the loan, including the principal amount, interest rate, and maturity date.Startups and other small businesses often use promissory notes to obtain funding from an individual, like a family member or friend. While a promissory note may seem like the only path to financing for your business, there are lenders on the market willing to work with borrowers of many credit profiles. Lantern by SoFi helps small businesses find the lending they need by matching them up with lenders who want to work with them. You can compare small business loans with one simple form.
Frequently Asked Questions
What must be included on a promissory note?
How legally binding are promissory notes?
What are promissory notes used for?
Photo credit: iStock/Paul Bradbury
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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.
