A promissory note is a written promise by one person to pay another person a sum of money. It is a financial document that describes a loan. But it can’t be that simple, can it? Read on to learn more.
What Is a Promissory Note?
The term may be new to you. But you have probably signed one. Most loan contracts are promissory notes. Sometimes the loan agreement may be called a note payable.
Have you bought a car on the installment plan or a house with a mortgage? Then you’ve signed a promissory note. Many personal loans are also made with these documents.
The promissory note spells out key information such as the loan amount. It tells who is borrowing money. It describes a repayment schedule and who will receive payments.
Standard Promissory Note Elements
In order to have a legally binding document, you’ll need to include a few things. Common elements of a promissory note include:
- Amount: The principal amount of the loan.
- Issuer/maker’s name: This is the person borrowing the money and promising to repay it. It may also give the issuer’s address.
- Payee’s name: This is the person who is lending the money and will be receiving payment. Address may appear here as well.
- Collateral: If the note is secured. An auto loan would normally be secured by the car. A loan to purchase a home would be secured by the home.
- Interest: If interest is being charged. The interest rate may be figured as simple interest or as compounded interest.
- Date: As you’d guess, the date the note was issued.
- Place: The location the note was issued. Usually, city and state will do.
- Due Dates: Specific dates on which payments are due.
- Amount of payments: Payments may be monthly or a single balloon payment.
- Terms of the loan: Any relevant terms, including whether there is a late fee for making past due payments. Terms may also call for a prepayment penalty for paying off the loan early.
- Signatures: All parties to the document must sign, including the payee and the issuer. Some states may require signatures be notarized to be legally enforceable.
While this is not a legal requirement, putting the term “promissory note” in the body of the document reinforces your intentions with the document. This will help ensure that there is no confusion about the intent of this document if you end up in a dispute.
Types of Promissory Notes
There are different types of promissory notes. A simple one may call for a single lump sum payment of an amount of money without any interest. A simple note is not too different from an IOU for a personal loan.
Most personal loans are unsecured notes. However, they can get more complicated. A secured contract is one common variation. A secured promissory note calls for the issuer to put up some kind of collateral.
If the issuer doesn’t pay back the money, the payee gets the collateral. Loan contracts from financial institutions are promissory notes. But they are a special type and more complicated.
Look at the fine print on any credit account to see how complex they can get. Whether simple or complex, promissory notes are legal financial documents. A properly drawn-up document can be enforced in a court of law.
Real Estate Uses
Promissory notes are often used in real estate. For example, say a homebuyer wants a house costing more than he or she can borrow. The seller of a home may accept a promissory note from the buyer for part of the purchase price.
Typically the seller carries back a contract for only a portion of the purchase price. The buyer gets a regular mortgage loan for the rest of the purchase price.
Promissory Note Example
Here’s an example of how this might work:
- Home price: $200,000
- Buyer can qualify for a mortgage loan of $150,000
- Seller agrees to a take-back mortgage promissory note for $50,000
- Combining proceeds from mortgage loan and loan, buyer pays $200,000 price
In this case, the seller of the home is providing the buyer with a 25 percent down payment. The seller may do this for several reasons, including:
- Get a higher price for the home
- Sell a home that has been on the market for a while
- Generate extra income from interest on the loan
A take-back mortgage will specify that a portion of the home’s equity is collateral or security. If the buyer fails to make the payments, the seller can claim the equity.
The seller, as holder of the take-back mortgage, has a second lien on the home. The mortgage company has the first lien. Say the borrower defaults on both mortgage and take-back mortgage.
The mortgage lender gets to claim its portion of the home equity. Then the second lienholder can take what’s left.
Mortgages as Promissory Notes
Student loans, auto loans and many other types of loans are promissory notes. And so are regular mortgages, at least in part. The document part of a mortgage describes the amount borrowed, interest and other terms.
That’s just like any promissory note. Until the mortgage is paid off, the lender will keep this promissory note. The mortgage itself is entered into county land records as a land contract.
The deed of trust or trust deed is also recorded in the public record. Because promissory notes are financial documents that can be enforced in court, investors may buy them.
Investors do this to get income from the interest charged on the promissory notes. When you are the payee on this document, be aware of relevant regulations and state laws.
Your local usury laws may cap the amount of interest you can charge. On the other hand, if you charge no interest, the IRS may consider your loan a gift. If that happens you could be liable for extra taxes.
Promissory Note Round-Up
Promissory notes are financial documents commonly used in many lending situations. You may use these documents to buy a house. Or you might use one to sell a house through a take-back mortgage.
You can find templates for promissory note forms online. But remember – a promissory note is a legal document, and a sample may not address your specific situation.
While we provide basic information about real estate topics, you should speak to an attorney if there is any question about these documents.