A promissory note differs from an IOU in that an IOU simply acknowledges the existence of a debt owed, while a promissory note, as its name implies, contains an undertaking (promise) to pay the amount stated. The following is not meant to provide legal or any other kind of advice. Nothing can replace the expertise of trained and experienced legal counsel. We recommend that the client and the person making a legal agreement each seek independent legal advice prior to entering into any complicated agreement, especially if large sums of money are involved.
A promissory note is a contract detailing the terms of a promise by one party (the borrower, sometimes also called the maker, obligor, payor, or promisor) to pay a sum of money to the other (the lender, or sometimes payee, obligee, promisee). The obligation may arise from the repayment of a loan or from another form of debt. For example, in the sale of a vehicle, the purchase price might be a combination of an immediate cash payment and a promissory note for the balance.
The terms of a note typically include the principal amount, the interest rate if any, and the maturity date.
For loans between individuals, writing and signing a promissory note is often considered a good idea for tax and record-keeping reasons.
At various times in the past, promissory notes have acted as a form of privately issued currency. Such promissory notes were written so that the borrower promised to “pay the bearer” the amount owing.You should be very cautious about writing a promissory note in which the person borrowing from you promises to pay “the bearer” as you might not be able to collect the debt. The original lender could then sell the note for cash, usually at a slight discount from the full value of the borrowing plus interest. In many jurisdictions today, bearer negotiable promissory notes are illegal precisely because they can act as an alternative currency.
Every promissory note should clearly set forth the repayment schedule. It should specify the amount of each payment, and when and where it is to be made.
Interest Rate Charged
The subject matter of a contract must be legal. For example, the law imposes limitations on interest amounts that can be charged on certain types of loans. So a loan agreement with an interest rate that exceeds the legal maximum is not a legal contract. Note that legal maximum interest rates cannot be avoided, even if both parties to a contract agree to a higher rate. Your local Better Business Bureau or library can tell you what the current legal maximum is.
Secured or Unsecured
A promissory note should always specify whether the loan is secured or unsecured. If the loan is unsecured, the lender has no priority over other creditors should the borrower default. If the loan is secured, the lender has prior claim to the property owned by the borrower that has been pledged to the lender as collateral. (If multiple creditors have recorded their interest, division of assets to repay the debt is generally calculated on a “who registered the borrowing first” basis.)
Registering your interest in a loan you made may not be important if the loan is for a small amount and among family members; in all other cases it is a good idea to register.
Types of Promissory Notes
A “lump sum” or simple note is unique in that repayment is in one lump sum at the end of the note. No periodic payments of interest or principal are contemplated with a simple note. As a result, such notes generally are used for a relatively short period of time and are often used between family members.
An installment note provides for periodic payments of principal and interest that will reduce the loan balance to zero by the end of the period specified in the note. A typical mortgage is an installment note — you pay an equal amount every month and that amount goes to repaying the interest and the principal, with the interest paid first. The reduction of principal through periodic payments over a period of time is referred to as amortization of the loan and so installment notes are sometimes called amortization notes.
An installment note may call for a balloon payment prior to the date at which the full amount of the loan would have been paid off if payments had continued (“installments with balloon”). Such a note combines features of an installment note and a simple note. The cost to the borrower is higher than that of an simple installment note, because the interest payments are higher.
A variation on the installments with balloon note is the “interest-only payments with balloon note” which only requires the borrower to make periodic interest payments for a certain period of time and then repay the balance in a single (balloon) payment. This might be used when the borrower is expecting a future payment that will be large enough to pay the balance owing. This is also the most expensive form of note for a borrower to sign, because of the impact of the interest payments.
Demand promissory notes are notes that do not carry a specific maturity date, but are due on demand of the lender. Usually the lender will only give the borrower a few days notice before the payment is due. A demand note is thus very risky for the borrower since the lender may call for payment with very little advance notice or prior scheduling.
Always sign the promissory note with the borrower and lender present, as well as adults to witness each signature. Some American states (e.g., California) require by law that a promissory noticed be signed in front of a notary. This is generally so the notary can establish the identity of each person and the genuineness of the signature attached to the instrument. Having a notary witness the signing in any jurisdiction can be a useful step to reducing future conflict in which the borrower might argue the signature on the note is not his or hers.
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