A promissory note is a contract that spells out the terms of a loan. It reduces misunderstandings and provides a legal remedy if the borrower doesn't pay or the lender oversteps its rights. If you're borrowing or lending money, you should consider having one—you can write one either as the borrower or the lender.
Learn more about how to write a promissory note and how to amend one.
What is a promissory note?
A promissory note is a written promise for one person (or company) to pay a specific amount of money to someone else. A promissory note includes much more detail than a simple IOU. It lays out all the specifics of the loan, including the amount, the interest rate, and when payments are due.
A promissory note is useful for both borrowers and lenders. For example, if your small business borrows money from a family member, a promissory note makes it clear that the money is a loan, not an investment that gives Uncle Joe a stake in the business. If you're lending money, it describes exactly how you expect to be repaid, and it helps you enforce your rights if the borrower doesn't pay.
Secured vs. unsecured promissory note
Before writing a promissory note, you must decide if the loan will be secured or unsecured. A secured promissory note is used if personal property or real estate is collateral for the loan. If the borrower doesn't pay, the lender can take the collateral. For example, auto loans are usually secured. If you don't make your payments, the lender can repossess your car.
An unsecured promissory note is a note without any collateral. You have to go to court to enforce an unsecured note. Short-term loans between friends and family members are usually unsecured.
Writing the promissory note terms
You don't have to write a promissory note from scratch. You can use a template or create a promissory note online. But before you begin, you'll need to gather some information and make decisions about the way the loan will be structured.
First, you'll need the names and addresses of both the lender (or "payee") and the borrower. You should then list the basic promissory note terms and conditions:
- The amount of money being lent.
- The interest rate, if you are charging interest. The interest rate shouldn't be higher than your state law allows.
- For a secured promissory note, the collateral or "security" being used.
You'll also include the promissory note payment terms, such as:
- The amount of each payment. You can require periodic payments at certain times, such as monthly. Or, repayment can be in a lump sum.
- When payments are due.
- The address where payments should be sent.
- Penalties for late payments.
A promissory note also describes the events that are considered a "default," and the lender's legal remedies if there is a default. For example, an event of default might be nonpayment for a particular amount of time, and the lender might be entitled to repossess the collateral.
Signing and storing a promissory note
A promissory note must be signed by the borrower to be valid. You may want the borrower to sign in front of a notary to ensure the signature is authentic.
The lender keeps the original promissory note and the borrower should receive a copy. Keep the promissory note with your other important papers, so you can find it if you need to.
Communicating changes to a promissory note
As time goes on, you may want to change the promissory note terms. For example, you might agree to change the interest rate or the length of the loan.
Always put promissory note changes in writing and have the borrower sign off on them, as oral changes can't be enforced in court. Changing a note without the borrower's written agreement makes a promissory note invalid. For this reason, the best way to change a note is to create a new document and label it as an amendment to the promissory note. Remember to make reference to the original promissory note and list the specific changes you're making. Then, have the borrower sign the amendment and keep it with the original note.
Writing a promissory note forces you to think through the specifics of a loan before money changes hands, as it reduces misunderstandings and gives you peace of mind knowing you have legal recourse if anything goes wrong.