A promissory note is a written promise to pay a specified sum of money to another party.
The note will normally specify terms under which payment is to be made. For example, the note may require the payment of a lump sum of money on a specified date, it may require periodic payments, or it may be payable on demand.
A well-drafted promissory note identifies:
- The parties to the agreement,
- The amount of the obligation,
- The consideration given in exchange for the obligation. (A description of what the debtor receives in exchange for signing the note),
- The interest rate (if any) that applies to the balance owed under the note, and
- Terms of repayment: When, where and how the obligation is to be repaid.
A promissory note may also include additional provisions. For example, a note may include an acceleration clause, a provision that makes the remaining balance of the note immediately due if a payment is missed.
The promissory note will be dated and signed by the party who is promising repayment.
When drafting a promissory note, be careful to consider state usury laws, the laws defining the maximum interest rate you are allowed to charge. Violations of usury laws may trigger serious civil consequences, such as the loss of any right to collect interest on the debt. Some violations may even result in criminal charges.
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 promises to repay the loan or obligation secured by the note. The promisor may also be called the payor or the obligor.
Promisee: A promisee is a person to whom a promise is made. In the context of a promissory note, the promisee (also known as the payee) is the person who is entitled to receive payment of the debt or obligation that is payable under the note. The promisee may also be called the payee or the obligee.
Consideration: The term "consideration" refers to the value received in exchange for entering into a contract.
For a contract to be valid there must ordinarily be mutual consideration, meaning that both parties to the contract receive something of value. 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.
Loan Agreements vs. Promissory Notes
There is no formal definition of "loan agreement" that distinguishes a loan agreement from a promissory note. However, the longer and more detailed the contract for repayment, the more likely it is that the agreement will be referenced as a loan agreement as opposed to a promissory note.
Sometimes a borrower will sign both a longer, more complex loan agreement that governs the terms of the loan and repayment, and also sign a shorter promissory note for the same loan or obligation. When asked to sign both documents, a borrower should verify that the promissory note refers to the loan agreement so that it is clear that only one debt is owed and that the full provisions of the longer loan agreement apply to payment and enforcement of the debt.
A promissory note will not ordinarily include restrictions that would prevent the promisee from transferring ownership of the note to another party. A loan agreement is more likely to include terms that restrict or prevent transfer of ownership without the consent of the promisee.
Promissory Notes vs. IOUs
An IOU ("I Owe You") is an informal term given for a very short promise to repay, perhaps providing little more than the identity of the promisor, promisee and amount to be repaid. An IOU may do little or nothing more than acknowledge a debt.
Without a recitation of consideration or repayment terms, a person who is attempting to collect money under an IOU may have difficulty convincing a court that the debt is valid or that payment is due.
When entering into a promissory note, both the promisor and the promisee must be careful not to make mistakes that may negatively affect their rights or the enforceability of the note.
Security for the Loan
A promissory note is normally an unsecured obligation, meaning that there is no collateral attached to the loan. When 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 against real estate, by recognition of the loan on the title to titled property (such as a registered lien on the title of a car or a boat that has a state-issued title), or through a UCC filing against business inventory for loans given to businesses.
If you lend money through an unsecured promissory note, never lend any more money than you are prepared to lose.
If you are loaning a larger sum, consider having your promissory note drafted by a lawyer. Your lawyer can ensure that the terms of the note are consistent with the laws of your state, and may advise you as to how you may secure the note so that you can recover the balance due in the event of the debtor's default or bankruptcy. A lawyer may also help you identify appropriate collateral for the note, and advise you as to how to best ensure that the collateral will be available to you in the event of a default.
Usury laws regulate interest rates, and set limits on the amount that can be legally charged for a debt.
A lender may face significant legal consequences for entering into a usurious contract. For example,
- In some states any interest payment made on a 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, usury may be treated as a criminal offense under laws meant to prevent loan sharking.
In order to avoid charging an unlawful interest rate, you should check your state's laws before setting the interest rate for a promissory note.
You cannot assume that an interest rate charged by a bank or credit card lender will be a legal rate for your promissory note. Private lenders are subject to different rules than commercial lenders. Many states place significantly lower limits on interest rates for loans issued by individuals than are permitted for loans from banks or commercial lenders.
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 a late fee must reasonably approximate the damages that you will suffer as a result of a late payment, and not be unreasonably large or punitive.
If a late fee is unreasonably high, the fee will be unenforceable and may carry other legal consequences for the enforceability of the note.
A promissory note should reflect how repayment is to be made. That is, the note should specify if repayment is to be made through a lump sum or through periodic payments, and should specify the date upon which payment is due or a payment schedule begins.
In the alternative, the note may provide that the balance due is payable on demand. When a note is payable on demand, the promisee may request payment in full at any time, and may pursue legal remedies if the note is not repaid at that time.
In the absence of a due date, payment schedule or due on demand clause, a promisee may have difficulty enforcing the note if the promisor fails to repay the loan. That is, if the note does not describe when repayment is to be made and the promisor fails to repay the note, no matter how much time has passed or how many demands for payment have been made, a court may be reluctant to find that a promisor has breached the terms of the note.
A promissory note is often the simplest mechanism to secure a debt. However, when the note is issued in association with the purchase or improvement of real estate, care must be taken by the lender to secure the loan. Loans issued for real estate purchases or improvements are often large in amount, and a mere promissory note may be insufficient to protect a lender if the promisor defaults.
If you lend money to help somebody with a real estate transaction, you may normally file a mortgage or lien in order to secure the loan. The lien or mortgage is recorded as a public document with a register of deeds office. Once recorded, it gives any subsequent lender or purchaser of the real estate notice of the obligation and of the fact that it is secured by the real estate.
When you properly record a mortgage or lien, unless that encumbrance is discharged at the time the property is transferred, a new purchaser will take the property subject to the lien. Similarly, if the property owner seeks another loan that will be secured by the real estate, your previously recorded mortgage or lien will normally give you priority over that subsequent loan, meaning that if the property is sold you will be paid first. Recording a mortgage or lien thus provides significant protection in event that borrower sells the property, borrows additional money against the property, or goes bankrupt.
Many office supply stores sell "fill in the blank" form mortgages. However, for larger amounts, it makes sense to have a lawyer assist you with the process of drafting the promissory note for the transaction, and with preparing and registering the mortgage or lien that will secure the note.
Promissory notes are simple documents. You can find examples online, and may be able to find standard form documents at an office supply store. Before you purchase a promissory note form, make sure that the form was drafted in a manner consistent with the laws of the state in which the note will be executed.
Be careful when using a standard form, as you must verify that any special provisions or terms included in the form are appropriate for your state. For example, a standard form may not advise you about your state's maximum lawful interest rate, or state restrictions on late fees. Even when that information is provided, you may discover that the information is out of date.
You may obtain an example promissory note form on this website.