What is a Promissory Note?

If you’ve ever taken out a student loan, purchased a home or got a personal loan for an urgent expense, you’ve probably signed a promissory note. A promissory note is a legally binding IOU, which is how a person promises to repay a specific amount of money to a lender, whether a financial institution or an individual within a defined timeframe. Like a contract, it acts like a safety net, helping to ensure smooth transactions and prevent misunderstandings.

How does a promissory note work?

A promissory note is a written promise between the borrower and the lender, designed to bind the parties to its terms. These terms typically outline:

• The principal amount borrowed
• The interest rate
• The repayment schedule
• Any fees that may apply to penalties for late payment or default Once both parties agree to the terms and sign the promissory note, it becomes a legally binding contract.

When do you use a promissory note?

Promissory notes are used in many different lending situations, including:

• Personal loans between adult individuals who can legally sign contracts
• Business loans
• Real estate transactions
• Financing for major purchases such as cars or appliances
• Higher education When money is borrowed, a promissory note formalizes the agreement and protects the interests of both the borrower and the lender. Some states have usury laws that limit the amount of interest that can be charged and charging more than these limits can lead to criminal charges.¹

What information is included in a promissory note?

Although it may differ depending on the scenario and the lender, a promissory note often includes these key elements:

• Parties involved: Names and contact information of the borrower and lender.
• Principal amount: The amount borrowed.
• Interest rate: If applicable, the rate at which interest accrues on the loan.
• Repayment terms: The schedule for repaying the loan, including the frequency of payments and the due dates.
• Late fees and penalties: Consequences for missing payments or defaulting on the loan.
• Collateral: For secured loans, details of any assets (typically a vehicle or property) used as security for the loan to ensure repayment.
• Governing law: Establishes which jurisdiction’s laws will apply if legal issues arise.
• Signatures: Both parties must sign the promissory note to make it legally enforceable.

Types of promissory notes

Promissory notes are used in different types of loans and transactions. Let’s look at some frequently used examples.

Promissory note for a secured loan

A secured loan is backed by something of value called collateral, like a home or car. If a borrower has, what credit bureaus define as, a fair or poor credit score, using collateral can improve their odds of getting approved for a loan — and more peace of mind for the lender. If the borrower defaults on the loan, the promissory note allows the lender to seize the collateral to recover the outstanding debt.

Promissory note for an unsecured loan

An unsecured loan does not require any collateral from the borrower, making it riskier for lenders. The borrower may choose an unsecured loan if they don’t have assets to offer as collateral or if they prefer not to put those assets at risk. Since there is no collateral involved, unsecured loans are approved based on the borrower’s creditworthiness and typically have higher interest rates to make up for the increased risk of default. If the borrower does not repay the loan, the promissory note allows the lender to proceed with the debt collection process to recover the borrowed funds.

Repayment

Repaying a promissory note usually follows the schedule agreed on when the documents are signed. The borrower is responsible for making timely payments according to those specific terms, including both the principal amount borrowed and any accrued interest. Generally, the promissory note outlines the consequences of not repaying. The legal impact could include default judgments, collection efforts or damage to the borrower's credit rating.²

A promissory note is a must have when borrowing funds

Promissory notes help with fair and transparent financial agreements by clearly outlining the terms of the loan, including repayment responsibilities and consequences for non-payment. Whether it’s a personal loan between you and a friend or a loan for a large transaction, a promissory note is the contract that makes sure the arrangement between the parties is structured and legally enforceable — protecting both parties so they can breathe a little easier.

Sources:
1. https://www.investopedia.com/terms/u/usury-laws.asp
2. https://finaid.uccs.edu/types-of-aid/educational-loans/default15