Whether you’re borrowing money from a financial institution or someone you know, a promissory note serves as a formal lending document. Promissory notes outline a loan agreement’s specific terms and conditions as a legally binding document that formalizes your commitment to repay a specified amount of money within a particular time frame.
“A promissory note is basically an IOU,” says Bill Maurer, director of the Institute for Money, Technology and Financial Inclusion at the University of California, Irvine. “It’s a written statement of a promise to pay a specific sum of money by a specific time. Think of it as an IOU that’s legally enforceable.”
Promissory notes protect both the borrower and the lender and provide loan details so your agreement is clear. Read this guide to understand how promissory notes work and when to use one.
[Read: Best Personal Loans.]
What’s Included in a Promissory Note
Promissory notes are legal documents outlining a promise to pay a specific sum of money by a specific time. These documents contain terms and conditions related to the loan agreement, including:
— The full names and contact information of the borrower and the lender
— The principal amount the borrower promises to repay
— The rate at which interest will accrue on the loan
— Repayment terms, which are the schedule and method for repaying the loan, including payment frequency and due dates
— The maturity date, which is when the entire loan amount, including interest, must be repaid
— Penalties, such as fees for late payments
— Collateral requirements, such as real estate or a vehicle
— Prepayment terms, including conditions or penalties for repaying the loan before its scheduled maturity date
— Governing law, or the state or jurisdiction whose laws will govern the promissory note
— Signatures of the borrower and lender, along with a witness and notary, as required in some jurisdictions
If you’re looking over a promissory note before you agree to a loan, carefully examine the details. Maurer recommends making sure you understand whether there’s a collateral obligation, the interest rate and how it works, the repayment schedule and what happens if you miss a payment.
[Read: Best Bad Credit Loans.]
Types of Promissory Notes
Each type of promissory note serves a different purpose or is appropriate in a different context. For example, a real estate promissory note outlines the details of a mortgage loan, while a Master Promissory Note is used for federal student loans.
These are some common promissory note types:
— Commercial promissory note. Used for business transactions, such as loans between companies or from companies to individuals for business purposes.
— Convertible promissory note. Generally used in startup funding, a convertible promissory note converts debt into equity ownership shares at a later funding round.
— Demand promissory note. This type of promissory note allows the lender to demand full repayment at any time — with reasonable notice — without a fixed repayment schedule.
— Installment promissory note. An especially common type of promissory note, an installment promissory note details a regular series of payments over a specified period until the debt is repaid.
— Joint and several promissory note. Used for multiple borrowers, a joint and several promissory note makes multiple borrowers responsible for the debt and enables the lender to collect the full amount from any one borrower or a combination of borrowers.
— Master Promissory Note. Used in federal student loans, a Master Promissory Note is an agreement between the borrower and U.S. Department of Education that covers the terms and conditions for multiple student loans over a specific period.
— Real estate promissory note. In a real estate promissory note, the borrower agrees to repay the loan for purchasing a property.
— Secured promissory note. A secured promissory note is used for loans backed by collateral, such as real estate, vehicles or other valuable assets the lender can claim to recover the loan amount if the borrower defaults.
— Simple promissory note. The most basic promissory note, a simple promissory note promises to repay a debt and outlines the terms of repayment and any applicable interest and fees.
— Unsecured promissory note. Unlike a secured promissory note, an unsecured promissory note is for loans that are not backed by collateral and rely solely on the borrower’s promise to repay the debt.
[CALCULATE: Estimate Your Monthly Payments on a Loan]
How Are Promissory Notes Used in Real Estate?
A real estate promissory note is a legally binding document that outlines a borrower’s promise to repay a mortgage by the loan’s maturity date. It serves as evidence of the debt and establishes the terms and conditions of the loan.
“A real estate promissory note has your rate, terms and stipulations,” says Dave Krichmar, a mortgage banker in Houston. “For example, when your payment is due and when it’s considered late.”
The promissory note is part of the real estate financing process and is used in mortgage transactions. It’s just one of the many documents you sign at the closing table for a mortgage loan.
How to Write a Promissory Note
If you need to create a promissory note because you’re considering lending money to someone, a lawyer can draw up a promissory note to create a legally valid document. Legal support is critical if you’re drafting a promissory note for significant loan amounts or complex transactions on which you might need legal or regulatory guidance.
You should understand the transaction and its principal amount, interest rate, repayment schedule, maturity date and other relevant terms to create the promissory note. Choose a template or create a format, then include necessary information using formal language and clear, straightforward terms.
Include necessary sections such as the parties involved, principal amount, repayment terms, interest rate, late payment penalties, maturity date and any collateral details. Be specific, using exact amounts both in words and numbers, and check for typos.
Sign and date the note, keeping a copy for your records. In some jurisdictions, you’ll need a witness and notary to make the document legally binding.
Promissory Notes for Friends and Family Loans
A promissory note can formalize a loan agreement between family and friends. It serves as a legally binding document that can make both parties feel more comfortable with the loan by clearly outlining the details, minimizing potential conflicts and misunderstandings. Your friends and family promissory note should include the loan amount, repayment schedule and any applicable interest rate.
“It’s boring but necessary because if anything goes wrong, you may need to go back to it and see what the terms are,” says Maurer.
[Read: Best Debt Consolidation Loans.]
More from U.S. News
5 Best Loans for Moving or Relocating
How to Get a Home Construction Loan
Your Guide to Promissory Notes originally appeared on usnews.com
Update 11/19/24: This story was previously published at an earlier date and has been updated with new information.
