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Table of Contents
What Is A Promissory Note
A promissory note is essentially a loan agreement.
In other words, promissory notes are lending documents where a borrower promises to repay the lender the amount that the parties have stipulated in the contract.
Typically, the promissory note will indicate how much the borrower must repay and by when.
Very often, you’re likely to see promissory notes issued by corporations in various types of business transactions.
For example, a corporate entity will execute a promissory note agreeing to repay another entity a certain amount by a certain date.
In recent years, we’ve seen more and more promissory notes being executed in the United States in the context of the sale of a home or for mortgages.
A company or person signing a promissory note will be legally bound to the obligation outlined in the note.
As a result, you should make sure that you understand the terms and conditions of the promissory note, understand your legal obligations, and that you can assume such obligations.
When To Use a Promissory Note
There are many situations when a promissory note may be used.
The most common use of promissory notes is in the context of commercial transactions such as business sales, sale of assets, mergers and acquisitions, or similar transactions.
Since a promissory note is a loan document, there are a variety of other situations where you may want to use a promissory note.
Other examples of when promissory notes may be used are:
- In real estate transactions
- In the context of student loans
- When selling a car
- When giving a personal loan
With a promissory note, you’re essentially trying to legally document a loan between the signing parties.
One party to the promissory note is the lender or creditor while the other party is the borrower.
When you lend money or want to legally create an indebtedness, you’ll use a promissory note to legally document the sums owed.
What Are The Different Types of Promissory Notes
There are different types of promissory notes.
You can classify the promissory notes depending on the nature of the transaction in which it is used or you can classify them based on how the loan is to be repaid.
Nature of Transaction Classification
If you’re classifying your promissory note based on the nature of the transaction, you can have:
- Personal promissory note
- Commercial promissory note
- Real estate promissory note
- Investment promissory note
A personal promissory note is when two individuals execute a promissory note in the context of a personal transaction.
For example, a friend may lend money to another friend or to document a loan between family members.
A commercial promissory note is when the promissory note is executed in the context of a business transaction.
For example, in the context of a merger and acquisition, the buyer executes a promissory note to pay the seller $100,000 within two years of the transaction.
Then you have the real estate promissory note which is one that may accompany a mortgage or real estate purchase agreement when buying or selling a home.
Finally, you have an investment promissory note which is one you sign when you’re raising capital.
For example, a company may issue a promissory note to an equity investor in the context of a corporate financing transaction.
Loan Repayment Classification
If you choose to classify your promissory notes based on the manner how the loan is repaid, you can have the following types of promissory notes:
- Lump-sum promissory notes
- On-Demand promissory notes
- Installment promissory notes
- Interest-bearing promissory notes
- Non-interest bearing promissory notes
A lump-sum promissory note is when where the borrower agrees to pay the lender the entire amount of the loan in one lump sum by or prior to a certain date.
A due-on-demand promissory note is when the borrower is obligated to repay the loan upon the lender’s demand.
An installment promissory note is when the borrower has the right to repay the loan in installments based on a payment schedule that has been mutually agreed in the note.
Interest-bearing promissory notes are a type of promissory note where the borrower agrees to repay the loan along with interest at a rate mutually agreed in the note.
Finally, a non-interest-bearing promissory note is when the parties agree that the borrower will pay the principal value of the loan without any interest charges.
How Promissory Notes Work
Promissory notes are legally enforceable agreements where one party is the creditor or lender and the other party is a borrower.
Promissory notes are legal agreements that are lighter than formal loan agreements but more extensive than simple IOUs.
In a loan agreement, you’ll typically have the borrower agreeing to repay a loan or sums received along with many protective provisions for the lender such as security agreements, default provisions, foreclosure procedures, and so on.
On the other hand, an IOU is a simple document where a person or entity simply acknowledges the existence of a debt and that one party is obligated to pay another.
IOUs do not extensively outline protective provisions in favor of the lender or what happens in case of default, etc.
In between the IOU and the loan contract, you have a promissory note where you have more than an acknowledgment of debt but you don’t have all the lender’s rights and recourses.
Promissory notes will typically outline the borrower’s indebtedness and include things like payment schedules and other procedural steps governing the debt.
From an international standpoint, promissory notes are governed by the 1930 Geneva Convention of Uniform Law on Bills of Exchange and Promissory Notes.
According to the 1930 Geneva Convention, promissory notes must state “promissory note” in the body of the instrument and contain an unconditional promise to pay.
What Are The Promissory Note Requirements
Although you need to make sure that your promissory note respects the local rules and requirements, here are some general guidelines to help you along the way.
In general, here are the promissory note requirements must include:
- The payor’s identification
- The payee’s identification
- The promissory note date
- The loan amount
- The interest rate on the loan (if any)
- The date payment is due
- The promissory term
In summary, the payor is the person or entity who is promising to pay the payee (so the borrower).
The payee is the person or entity expecting to be paid (the lender).
The promissory note date is the date at which the debt becomes effective and the document acquires a legally binding effect.
The loan amount or principal amount is how much the payor is legally agreeing to pay the payor (it represents the total value of the loan or debt).
If the promissory note bears interest, then the parties will stipulate the rate of interest applicable to the loan.
With respect to the payor’s payment obligation, the promissory note will stipulate the first day where payment will be due and by when the payments will end.
Ultimlatey, the promissory note will have a term establishing the date on which the note will terminate.
Generally, the contract is terminated when the payor makes all the payments provided under the note.
Take note that most promissory notes do not include any prepayment penalties or fees on the payor for making early payments.
What Type of Promissory Note Do You Need
The exact type of promissory note that you need will largely depend on the nature of your transaction.
In some situations, you want to keep the document as simple as possible whereas in other cases the note will have more complex legal provisions.
In its most simple form, the promissory note will identify the lender and borrower, set the value of the loan, establish a repayment obligation, and the repayment date.
In more complex transactions, promissory notes may be due on demand, be convertible into equity securities, include amortization schedules, have specific terms governing the interest charges, and so on.
Look at the nature of your transaction to assess how simple or complex your note should be to provide you with the right level of protection you might need.
If you’re not sure, you may consult a few promissory note templates so you can better assess which one is more suitable for you.
If you’re still not sure, it may be a good idea to consult with a qualified business attorney.
How Do You Collect On A Promissory Note
A promissory note is a legally binding document that is enforceable by the courts.
This means that a payor who does not respect his or her payment obligation can be legally compelled to make the required payment.
What happens when a payor does not pay the payee as per the terms of the promissory note?
Typically, when the payor defaults on a payment, the payee will send a written notice requiring the payor to pay what’s owed under the promissory note.
In some cases, the payor will have some delays in paying but will end up paying the note.
If the payor still fails to pay, the next step is to seek other collection alternatives.
One way is to contact a debt collector who will take the necessary measures to collect the debt but will take a percentage of the proceeds in compensation.
Alternatively, the payee can file a lawsuit against the payor legally claiming the repayment of the promissory note.
Since the promissory note is a legal document evidencing the borrower’s debt in favor of the payee, the courts will consider the promissory note as valid and binding.
The issue before the court will revolve around the repayment and the circumstances of the payor’s default.
Difference Between Promissory Notes And Mortgages
What is the difference between a promissory note and a mortgage?
The main difference between a promissory note and a mortgage is that the former is a promise to pay whereas the latter documents the rights and recourses of the lender when the borrower defaults on payment.
In other words, when you sign a promissory note, you’re legally documenting the borrower’s obligation to pay you a certain amount of money by a certain time.
The note will not include the lender’s rights and recourses in detail.
On the other hand, a mortgage, or a deed of trust, is a legal document intended to detail the lender’s rights and recourses in the event of a borrower’s default.
Typically, through a mortgage, the borrower agrees to grant a lien or security on personal assets or property owned to secure the principal and interest on the loan.
In some cases, for instance, in some real estate transactions, a promissory note may be signed to accompany a mortgage.
For example, if the buyer obtains financing from the bank and the seller at the same time, the bank may require a mortgage agreement whereas the seller may get a promissory note.
What Is Promissory Note Takeaways
So there you have it folks!
In a nutshell, a promissory note is a debt instrument where one party promises to pay another party a certain sum of money.
The borrower’s repayment obligation can be outlined in a repayment schedule or it may be in a lump sum.
The borrower may have time to pay or the note may become payable on demand.
No matter what type of promissory note you’re looking to execute, be sure to read and understand its terms and conditions to avoid any surprises.
You may choose to use a promissory note template, draft one yourself, or hire an attorney to provide you with the required services depending on your specific needs and complexity of your transaction.
Now that you know what a promissory note means and how it works, good luck in documenting your loan!
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