Basics of Promissory Note

A promissory note is a debt instrument that contains a written commitment by one party (the note’s issuer or maker) to pay another party (the note’s payee) a specific amount of money, either immediately or at a later date. A promissory note usually includes all the details of the debt, including the principal amount, interest rate, maturity date, date and location of issuance, and the signature of the issuer. Although they may be issued by financial institutions, for example, you may be asked to sign a promissory note in order to obtain a small personal loan. Promissory notes typically allow businesses and people to obtain funding from sources other than banks. This source could be an individual or a business prepared to carry the note (and supply the funding) on the agreed-upon terms. Promissory notes, in effect, allow anyone to be a lender.

What Is a Promissory Note?

A promissory note is a written promise by one party (the note’s issuer or maker) to pay another party (the note’s payee) a definite sum of money, either on demand or at a specified future date. A promissory note typically contains all the terms involved, such as the principal debt amount, interest rate, maturity date, payment schedule, the date and place of issuance, and the issuer’s signature.

How Promissory Notes Work

Promissory notes can lie between an IOU’s informality and a loan contract’s rigidity. An IOU merely acknowledges a debt and the amount one party owes another. A promissory note includes a promise to pay on demand or at a specified future date, in addition to steps required for repayment (like the repayment schedule)

Although financial institutions may issue promissory notes—for instance, you might be required to sign one to take out a small personal loan—they also allow companies and individuals to get financing from a non-bank source. This source can be an individual or a company willing to carry the note (and provide the financing) under the agreed-upon terms. In effect, promissory notes can enable anyone to be a lender.

Necessities of a promissory note

The document must contain an unconditional undertaking to pay.
The undertaking must be to pay money only.
The money to be paid must be certain.
It must be payable to or to the order of someone in particular or to the bearer.
The record must be signed by the creator.

Parties in a promissory note

Drawer or Maker: The promisor, also known as the maker or issuer of the promissory note, is the person who creates or issues the promissory note that specifies the sum to be paid.
Drawee or Payee: It is the individual on whose behalf the promissory note is made or issued, also known as the promisee. Unless the note specifies a different person as the payee, the said individual is also the payee.

Methods of repayment of a promissory note

Lump-sum payment: This means that at the end of the period, the full note is paid in one payment. Only if you are interested.
Interest-only: This means that the regular payments are applied only to the interest that has accrued, not to the principal.
Interest and principal repayment: The funds are being applied to both the accrued interest and the note’s principal amount.

Advantages of a promissory note

Flexibility: Flexibility is a crucial benefit of a promissory note, whether you are the borrower or the one supplying the funds. You can select how payments will be made in instalments, at a later date, or on-demand using a promissory note. You could, for example, make interest-only instalments with a balloon, a one-time payment, at the end. You can either fully amortise the loan and make monthly payments, or you can make equal quarterly or semi-annual instalments. This flexibility allows you to choose loan terms that best suit your or your company’s needs.
Convertible: A convertible promissory note can be used to entice potential investors if your company operates as a corporation, LLC, or other separate legal entity. Investors may be interested in your firm if they believe you have sufficient cash flow to repay the principal plus interest. They may not believe in your firm enough to invest in its stock outright, or they may not know how to value it. An investor can convert a convertible promissory note into preferred stock or a preferred interest in your firm at a later date or when a specific event occurs.
Brief and often unsecured: Unlike traditional loans, which can be hundreds of pages long, promissory notes are usually only a few pages long. As a result, the legal fees associated with preparing a promissory note are typically substantially lower than those associated with preparing a regular loan agreement. It is not necessary to have a promissory note notarized or recorded in order for it to be valid. As a result, you can use a promissory note as an unsecured loan while securing bank or other loans with your assets.

Disadvantages of a promissory note

Short-term service: It is only suitable for short-term services. It cannot be used as a source of capital for large projects.
Detriment to new borrowers: For new borrowers, it is a dangerous credit instrument because the note’s seemingly short and straightforward language may conceal certain unfavourable provisions. As a result, the borrower may be forced to pay a large sum to cover the responsibilities incurred.

Difference between a mortgage and a promissory note

A ‘promissory note’ is like an IOU which includes the borrower’s agreement to pay off the debt as well as meet all the repayment terms. Only those who sign the promissory note are legally responsible for repaying the lender. The note is inclusive of borrowers’ names, property’s address, interest rate (fixed or adjustable), the late charge amount, amount of the loan, and term (number of years). The promissory note, unlike a mortgage, is not recorded in the county land records. While the loan is in progress, the promissory note is held by the lender. The note is marked ‘paid in full’ and returned to the borrower when the loan is paid fully.
The borrowers’ names, the property address, and the legal description of the property are all listed on the mortgage. It also includes all of the deal’s major terms and conditions. The mortgage has an ‘acceleration clause’ in addition to conventional lender-borrower conditions. If the borrower defaults, such as by not making payments, the lender might demand that the whole loan sum be repaid. Before accelerating a loan, the lender must usually give the borrower notice. If the borrower fails to correct the default, the lender may pursue foreclosure. Foreclosure refers to the legal process of selling real estate that is secured by a mortgage in order to pay off the debt.
The promissory note is endorsed (signed over) to the new owner of the loan when it changes hands. The note may be endorsed in blank, making it a bearer instrument in some instances. As a result, anyone who has possession of the note has the legal ability to enforce it. The legal record of a mortgage transfer from one holder (loan owner) to another is called a ‘mortgage assignment.’ In most cases, each assignment is required to be recorded in the country land records.

Types of promissory notes

Corporate credit promissory notes

Promissory notes are a type of short-term borrowing often employed in the business. For example, if a company sells a lot of things but doesn’t get paid for them, it may run out of funds and be unable to pay its creditors. In this scenario, it may request that they accept a promissory note that may be swapped for cash after it collects its receivables. It might also ask the bank for the money in exchange for a promissory note that will be paid back later.
Companies who have exhausted all other options, such as corporate loans or bond issuance, can use promissory notes as a source of credit. In this case, a note issued by a firm has a higher chance of default than, say, a corporate bond. This also indicates that a corporate promissory note’s interest rate is more likely to generate a larger return than a bond issued by the same company as high-risk means higher potential rewards.
Typically, these notes must be registered with the government of the state in which they are sold, as well as the Securities and Exchange Commission (SEC). Regulators will go to the memo to see if the company can deliver on its commitments. If the note isn’t registered, the investor must conduct their own due diligence to determine whether the company is capable of repaying the debt. In this instance, the investor’s legal options in the event of default may be limited. Insolvent businesses may hire high-commission brokers to sell unregistered notes to the general public.

Student loan promissory notes

Deciding on the college or university of your choice and enrolling in that institution can be an exciting time, but it can also feel overwhelming with so much to plan and do before your first semester. If you are like the majority of students who will need to borrow student loans to cover some or all of the cost of higher education, it may also lead to your first encounter with any type of loan or credit product. When you sign a student loan contract, known as a promissory note, you agree to all of the terms and conditions laid out by the lender. As with any legally binding document, it’s important to read a student loan promissory note carefully and be aware of and understand your rights, responsibilities and obligations before moving forward.
When a student takes out a loan for student financial aid, they usually sign a promissory note to formalise the debt. Interest does not usually begin to accrue until after the student graduates, according to the promissory note agreement. Students can typically sign a master promissory note that covers the duration of their education and eliminates the need to re-sign each year they take out a school loan.
You can sign a contract called a Master Promissory Note, or MPN, for federal student loans that permit you to borrow multiple loans over a 10-year period. Depending on whether you wish to borrow federal direct loans for undergraduate or graduate students, PLUS loans for graduate students, Parent PLUS loans, or a combination of loan types, you will need to sign a new Master Promissory Note for each form of a loan. Your terms and conditions will not change if you enter into this form of agreement. You won’t have to sign a new agreement every year as long as you keep taking out federal student loans.
A variable interest rate or a fixed interest rate can be applied to student loans. Your interest rate on a fixed-rate loan will remain the same for the duration of the loan. A variable interest rate loan has an interest rate that fluctuates based on a market benchmark or index that changes on a regular basis.

Informal promissory notes

An informal promissory note, also known as a personal promissory note, is used when two people, such as friends or family members, need to borrow money. It is a written agreement between the payor and the payee that a quantity of money will be reimbursed within a specified time period, and it may not contain as many repayment stipulations as other more formal promissory notes.

Real estate promissory notes

People who might have qualified for a mortgage previous to the recession are having a hard time finding lenders prepared to lend to anyone other than highly qualified buyers. This condition not only prohibits good potential buyers from acquiring a home, but it also disadvantages sellers because it is considerably more difficult to find purchasers who qualify for traditional financing. This has led to an increase in the number of sellers marketing their own homes and using legal promissory notes to sell their properties to potential buyers.
At the beginning of a mortgage for a real estate home loan, a bank may issue a real estate promissory note. This is especially important if the lending partner is not a bank but a private individual. These promissory notes state that the borrower’s home as collateral for the loan and that the creditor or issuer can place a lien on the property if the borrower fails to pay by a certain date or defaults on the loan.
Promissory notes are perfect for people who don’t qualify for typical mortgages since they allow them to buy a home with a loan from the seller and collateral from the purchased home. The buyer makes a down payment to the seller as a sign of good faith and as a guarantee that the debt will be paid back. The deed to the house serves as collateral on the loan, and if the buyer defaults, the seller keeps the deed and the down payment. The promissory note stipulates all of the loan’s repayment terms, as well as the repercussions of defaulting on the loan.

Commercial promissory notes

Commercial paper, often known as CP, is a short-term financial instrument used by businesses to raise capital over a one-year period. It is an unsecured money market instrument in the form of a promissory note that was first established in India in 1990.
A commercial promissory note is a formal type of promissory note that is often issued to borrowers by institutions such as credit unions or banks. These could be used by commercial lenders to make auto loans, personal loans, or business loans to private individuals.

Investment promissory notes

Even in the case of a take-back mortgage, investing in promissory notes entails risk. To assist mitigate these risks, an investor should register or notarize the note so that the obligation is both publicly recorded and lawful. In the case of a take-back mortgage, the note purchaser may even go so far as to purchase a life insurance policy on the issuer. This is fine because if the issuer dies, the note holder will inherit the house and all associated expenses, which they may not be prepared to handle.
These notes are only available to corporate or sophisticated investors who are ready to take on the risks and have the funds to purchase the note (notes can be issued for as large a sum as the buyer is willing to carry). After agreeing to the terms of a promissory note, an investor might sell it (or individual payments from it) to another investor, similar to a security.
Because the value of future payments is eroded by inflation, notes are sold at a discount to their face value. Other investors can buy a portion of the note by purchasing the rights to a specific number of instalments at a discount to the true value of each payment. This allows the note holder to raise a lump sum of money quickly, rather than waiting for payments to accumulate.

FAQs

What Does a Promissory Note Contain?

A form of debt instrument, a promissory note represents a written promise on the part of the issuer to pay back another party. A promissory note will include the agreed-upon terms between the two parties, such as the maturity date, principal, interest, and issuer’s signature. Essentially, a promissory note allows entities other than financial institutions to provide lending services to other entities.

What Is an Example of a Promissory Note?

One example of a promissory note is a corporate credit promissory note. For this type of promissory note, a company will typically be seeking a short-term loan. In the case of a growing startup that is low on cash as it expands its operations, the terms of the agreement could state that the company pays back the loan once its accounts receivable are collected.

There are several other types of promissory notes, including investment promissory notes, take-back mortgages, and student loan promissory notes.

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