Whether you are lending or borrowing money, you can protect your financial interests with a promissory note. This valuable legal tool can be used in both personal and business transactions.
Promissory note basics
A promissory note is a legal document that obligates the person who signs it to pay a certain sum of money to another person at a later date. The person who owes the money is called the payor, maker, issuer, or promissor. The person who is owed the money is called the payee or promissee. A promissory note is sometimes called a note payable, or simply a note.
A promissory note is typically a short and simple document. It indicates the names of the parties, the amount that is owed, and when payment is due. There are options specific to how payment is made: The promissory note may require periodic payments, payment of the full amount on a certain date, or payment of the full amount at any time upon the demand of the payee.
Depending upon the agreement of the parties, a promissory note may also state an interest rate to be paid.
If the note provides for payment of the full amount at one time, rather than periodic payments, it is called a lump sum payment. It is a loan with a lump sum payment whether payment is due on a certain date or upon the demand of the payee.
A promissory note also can be either secured or unsecured:
- A note that is secured by specific property is called a secured promissory note. This allows the payee to take the property if the payor fails to pay the loan when it is due. The property that secures the loan is called collateral.
- An unsecured promissory note does not have any property attached to it. If the payor fails to pay, the payee can file a lawsuit to try to recover what is owed. However, an unsecured loan is often more difficult to collect than a secured loan, especially if the payor has limited assets.
From the lender's standpoint, it is better to have a secured promissory note. From the borrower's standpoint, it is better to have an unsecured note.
Generally, it is possible for the payee to sell a promissory note, unless the note specifies otherwise. The party purchasing a note will buy it for less than the amount to be repaid, making a profit when the loan is paid.
Real estate loans
The most common situation in which most people encounter a promissory note is when they buy real estate. Buying real estate typically involves the purchaser's signing a promissory note for the amount that is being borrowed to finance the purchase, and signing a mortgage or deed of trust to secure the note.
Promissory notes are sometimes used for loans between friends or relatives. Especially if a significant amount is being loaned, it is a good idea to have a promissory note to assure the payee's ability to get repaid from the payor's estate in the event of the death of the payor.
If the loan is for a relatively small amount that is to be paid back in a relatively short period of time, it is common for friends and relatives to use a promissory note for a personal loan with a lump sum payment without interest. Such loans are often unsecured, although some people will make a personal loan with collateral. However, caution should be used with a no-interest or low-interest loan, as there can be tax implications for the borrower, because the Internal Revenue Service (IRS) expects loans to pay at least a minimum amount of interest.
Promissory note for business
A business enterprise may use promissory notes for various purposes. As a payor, the business can obligate itself with a promissory note in order to raise capital for the business, or to purchase assets for the business. As a payee, a business can require a promissory note from a customer who is buying from the business on credit.