What Is a Promissory Note?

A promissory note is a written promise to pay a specified amount within a specific time period. This type of document is used by the lender to enforce a borrower's promise to pay back a loan.

A promissory note is a type of contract. Like a contract, a promissory note details all the terms of a loan agreement, including the following:

• The identity of the lender and borrower

• The date by when the loan is to be paid in full

• How the borrower is to pay the loan

• How much the borrower is required to pay

Promissory notes are common documents in any financial transaction. You've likely signed one if you have taken out any type of loan in the past. Common transactions include a loan to purchase your residence, a loan to purchase a vehicle or a loan involving a business matter.

When Should You Use a Promissory Note?

A promissory note is commonly used for the following transactions:

• Business loans

• Car loans

• Real estate purchases

• Personal loans among friends or family

• Student loans

If you are lending a person or a business money, we strongly recommend that you formalize the loan by creating a written promissory note. Whether you are lending a small or large amount of money, it’s important to get it in writing. The promissory note is an enforceable agreement, helping to protect you and to ensure that a person or organization repays you.

Common types of promissory notes include the following:

Commercial

These notes are more formal and detail specific conditions of a loan.

Investment

A business can decide to issue a promissory note to raise capital.

Personal or Informal

These notes generally involve one family member or friend loaning a sum of money to another family member or friend.

Real Estate

These notes accompany a home loan or other real estate purchase.

What Should You Include in a Promissory Note?

Since every state has its own laws governing the essential components of a promissory note, you'll want to verify the laws of your state when writing a promissory note. No matter your state of residence, these important details should be addressed in your promissory note:

Payer or Borrower

Include the name and address of the person who promises to repay the loan

Payee, Holder or Lender

Include the name of the lender, the person or entity, lending the money and to whom the payments must be made

Date

State the date that the loan was made

Amount or Principal

State the face amount of the money borrowed

Interest Rate

If the loan involves interest, the promissory note should include the interest rate charged. The interest rate may be simple or compounded, fixed or adjustable. *Insider’s Tip: Imputed Interest Sometimes friends make a loan without interest. Imputed interest is interest that the IRS tax code assumes you collected but you didn't actually collect. It’s possible that the lender or borrower will have to pay taxes based on imputed interest even if the promissory note does not include interest or if the interest rate is below the market rate.

Date First Payment is Due

A common arrangement is to have the first payment due on the first day of the month and subsequent payments due on the first date of the following months. Typically notes are paid “in arrears”. Simply put, the payment you make on the first of each month pays the interest for the month just ended and the principal for the month ahead.

Details of Each Payment

If multiple payments are due, the promissory note should include how often payments will be made as well as the amount of each payment.

Where Payments Are To Be Made

The note should state specifically where payments are to be made, such as an address.

Date the Promissory Note Ends

In the case of an amortized loan, a loan paid off in a series of even and equal payments on a specified date, the date the note ends could be the last payment. An agreement could also involve a balloon payment, specifying a date on which the entire unpaid balance is due.

Signatures

For a promissory note to be legal enforceable, it must be signed by the borrower. It is good practice to have the borrower’s signature notarized.

Types of Promissory Notes

Different types of promissory notes are appropriate for different types of agreements. You should create your promissory note to fit the type of transaction in which you're involved. Promissory notes can be as simple as a onetime payment from a friend in the future (a demand note). Transactions such as car loans and real estate loans require more complex promissory notes that cover details such as amortization schedules, interest rates, and more.

Types of promissory notes include the following:

Simple Promissory Note

If you're writing a promissory note for a lump sum (one time)repayment, you'll typically use a simple promissory note. An example is lending your sibling $2,000. Your sibling agrees to pay you money back by January 1 the following year. A simple promissory note will state the full amount is due on the stated date; you won't need a payment schedule. You can decide whether to charge interest on the loan amount and include the interest in the document if needed.

Demand Promissory Note

A demand promissory note makes payment due when the lender asks for the money back. You will typically need to provide a reasonable amount of notice to use this type of promissory note.

Secured Promissory Note

A secured promissory note secures the amount loaned with an asset of value, for example, a home or vehicle. If the borrower does not pay back the loan amount within the agreed-upon time frame, the lender has the right to seize property of the borrower.

Secured promissory notes often require multiple documents in order for you to have a “lien” on the asset securing the loan. For example, when you buy a house, the house is collateral on your loan. You sign a separate document, called a mortgage, which is evidence that you have pledged your home as collateral for your obligation to repay the loan. The lender can foreclose on and sell your home if you do not make payments required in the promissory note.

Unsecured Promissory Note

This type of promissory note does not allow the party lending the money to secure an asset for the loan. If the borrower does not make the payment, the lender must instead file in small claims court or go through other legal processes to enforce the note.

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If you have a situation where a promissory note is advisable, make sure to include all important details to protect yourself. Get in touch with one of our experienced business attorneys for help drafting your promissory note. Protect yourself. You can even have the attorneys fees made part of the loan and paid back by the borrower.