How to Use a Promissory Note

What Is A Promissory Note?

In it simplest terms, a promissory note is a written promise to repay a loan or debt under specific terms, usually at a stated time, through a specified series of payments, or upon demand.

A promissory note will identify the parties, the amount of the obligation, some form of recitation of the consideration for the obligation (that is, what the debtor received in return for signing the note) and will usually include the terms of repayment, the interest rate which will apply (if any). It may also include an acceleration clause, that will make the entire amount of the note due if a payment is missed.

When drafting a promissory note, be careful to consider state usury laws, the laws defining the maximum interest rate you are allowed to charge. You can trigger serious civil consequences, and sometimes even face criminal charges, for violating usury laws.

Legal Terms

The following legal terms may be used in a promissory note:

  • Promisor - A promisor is the person who makes a promise. In the context of a promissory note, the promisor is the person who is promising to repay the loan or obligation secured by the note.

  • Promisee - A promisee is a person to whom a promise is made. In the context of a promissory note, the promisee is the person who is entitled to receive payment for the loan or obligation secured by the note.

  • Obligor - An obligor is a person who is bound to fulfill an obligation to another person by contract or legal agreement. In the context of a promissory note, "obligor" is another word for "promisor".

  • Obligee - An obligee is a person to whom another is bound by contract or legal agreement. In the context of a promissory note, "obligee" is another word for "promisee".

  • Consideration - The term "consideration" refers to the value received in return for entering into a contract. For a contract to be valid there must ordinarily be mutual consideration, with something of value received by both parties to the contract. In the context of a promissory note, the promisor obtains consideration in the form of a loan, and the promisee receives consideration in the form of the promise to repay under the terms specified in the note.

Potential Pitfalls in Promissory Notes

  • Security for the Loan - A promissory note is usually an unsecured obligation, meaning that there is no collateral attached to the loan. If a debt is unsecured, in the event that the borrower declares bankruptcy the debt secured by the note will only be repaid after all debts to secured creditors have been paid. If a loan is large, it thus makes sense to obtain security for the loan. For example, the loan might be secured by a lien or mortgage against real estate, by recognition of the loan on the title to titled property (such as cars and certain boats), or through a UCC filing against business inventory for loans given to businesses.

    If you are lending money through an unsecured promissory note, a good rule of thumb is to never lend any more money than you are prepared to lose. If you are loaning a larger sum, consider consulting a lawyer to make sure that your promissory note is bulletproof, to determine how you might secure your note to ensure that you will eventually recover the balance of the loan, and to make sure that your promised collateral will in fact be applied to the debt in the event of default.

  • Usury Laws - The term, usury, refers to an unlawfully high interest rate. A lender can face significant legal consequences for entering into a usurious contract. For example, in some states any interest payment made on an usurious loan is applied to the principal balance of the loan -- that is, the law transforms the loan into a zero interest loan. When interest rates are very high, under laws meant to prevent loan sharking, usury may be treated as a criminal offense.

    Please note that private lenders are be subject to different rules than commercial lenders. The mere fact that a bank or credit card company charges a particular interest rate does not mean that an individual can lawfully charge a similar rate. Many jurisdictions place significantly lower limits on loans from individuals than are permitted for loans from banks or commercial lenders. Check your local laws before setting the interest rate for a promissory note.

  • Late Fees - As with interest rates, states impose limits upon the late fees you may assess against a borrower in the event of late payment. In most cases the standard is that the fee must be a reasonable approximation of the damages you will suffer as a result of a late payment, and not be unreasonably large or punitive. Check your local laws before setting the late fees for a promissory note.

  • Due Date - A promissory note should reflect how repayment is to be made (e.g., in a lump sum or through periodic payments), and a date upon which payment is due or a payment schedule begins. In the alternative, the note may provide that the loan is due on demand of the promisee. In the absence of a due date or due on demand clause, the promisee may have difficulty enforcing the note if the promisor fails to repay the loan.

Real Estate Loans

While a promissory note may provide the simplest mechanism to secure a debt, care should be taken if the note relates to a loan for the purchase or improvement of real estate. As such loans may be quite substantial, a mere promissory note is not likely to provide the lender with adequate protection in the event that the promisor defaults.

If you are lending money to help somebody with a real estate transaction, you can usually file a mortgage or lien in order to secure the loan. The lien or mortgage is recorded as a public document, and gives any subsequent purchaser of the real estate notice of the obligation and the fact that it is secured by the real estate. Unless your lien or mortgage is discharged at the time the property is transferred, the new purchaser will take the property subject to the lien. Having a properly filed mortgage or lien provides you with significant protection in case the borrower goes bankrupt, or if the property is sold.

Many office supply stores sell "fill in the blank" form mortgages. For assistance in properly preparing a mortgage, particularly for larger loans, you may benefit from the assistance of a lawyer or real estate professional who can ensure that all documents and forms are in proper form and are properly filed and recorded with the Register of Deeds.

Promissory Note Forms

As with mortgage forms, you will often be able to find state-specific promissory note forms at an office supply store. These standard forms often include instruction, including information about maximum allowable interest rates. Although most forms sold in this manner are reliable, please be aware that the instructions may be out of date.

There are also numerous websites that will allow you provide promissory note forms, some for free and some for purchase. Please be certain that the note you purchase online is valid in your jurisdiction before making your purchase.

You may review an example promissory note form on this website.

Copyright © 2003 Aaron Larson, All rights reserved. No portion of this article may be reproduced without the express written permission of the copyright holder. If you use a quotation, excerpt or paraphrase of this article, except as otherwise authorized in writing by the author of the article you must cite this article as a source for your work and include a link back to the original article from any online materials that incorporate or are derived from the content of this article.

This article was last reviewed or amended on Nov 25, 2016.