A promissory note is a financial tool used to put the terms of a loan in writing. The note spells out the amount borrowed by one party, as well as how and when the money will be paid back. A promissory note is a legal contract that binds the borrower by law. If the borrower fails to repay the money according to the terms of the note, the lender may file a civil lawsuit to obtain a judgment, and possibly take additional action, to get his money back. To explore this concept, consider the following promissory note definition.
Definition of Promissory Note
- A written promise to pay a specified amount of money to a specific person, by a specified date.
What is a Promissory Note
A promissory note is a written and signed contract in which one party promises to pay a specified amount of money to the other party. The terms of a promissory can be tailored to the parties’ needs, as far as the amount borrowed, whether interest will be charged, the schedule or date by which the money must be repaid, and any other needed particulars.
There is no requirement that a promissory note be made on a certain type of paper or document, or that it contain complex language, though it is important to be as specific as possible. In fact, a promissory written and signed on a scrap piece of paper, back of a napkin, or even in an email or text message, is just as valid as a note drawn up by a lawyer.
Example of an Informal Promissory Note
Mike and John are having a beer at the local pub after work when John mentioned he needed to come up with $1,000 to send to his ex-wife by the end of the week, or he would be in trouble with the family court judge. Mike offered to lend John the money, if John could repay it by the 15th of the following month. John agreed, and Mike grabbed a cardboard drink coaster, and borrowed a pen from a waitress. He wrote the following on the coaster:
“I, John Smith, borrowed $1,000 Mike Brown, and promise to repay the entire amount by March 15, 2015.”
He had John sign the coaster and stuck it in his pocket. When John had not repaid the money by July, and avoided making a commitment to a payment arrangement, Mike filed a civil lawsuit. At the small claims court trial, Mike gives the promissory note drink coaster, with John’s signature on it, to the judge. The judge rules that the coaster is a valid contract, and that John must repay Mike the entire amount of the loan immediately.
Types of Promissory Note
Though every good promissory note contains certain elements, there are several types of promissory note. These notes are largely classified by the type of loan issued, or purpose for the loan. All of the following types of promissory note are legally binding contracts.
Personal Promissory Note
This type is used to record a personal loan made between two parties. While not all lenders use legal writings when dealing with friends and family, it helps avoid confusion and hurt feelings later. A personal promissory note shows good faith on behalf of the borrower, and provides the lender with recourse should the borrower fail to pay back the loan.
Commercial Promissory Note
A commercial promissory note is typically required with commercial lenders. Commercial promissory notes are often more strict than personal notes. If the borrower defaults on its loan, the commercial lender is entitled to immediate payment of the full balance, not just the past due amount. In most cases, the lender on a commercial promissory note can place a lien on the borrower’s property until payment in full is received.
Real Estate Promissory Note
A real estate promissory note is similar to a commercial note, as it often stipulates that a lien can be placed on the borrower’s home or other property if he defaults. If the borrower does default on a real estate loan, the information can become public record.
Investment Promissory Notes
An investment promissory note is often used in a business transaction. Investment promissory notes are exchanged to raise capital for the business, and they often contain clauses that deal with returns on investments for specific periods of time.
Differences Between a Promissory Note, a Loan Agreement, and an IOU
When someone borrows money, or makes a purchase without paying for it up front, there are many ways to document that repayment is expected. While all three contracts spell out such terms, there are certain differences between a promissory note, a loan agreement, and an IOU.
|Includes Timeline for Repayment||
|Specifies Interest Rate||
|Requires Repayment in Installments||
|Specifies Rigid Consequences for Non-Payment||
Promissory Note Payment Options
While promissory notes may be used in certain formal loans, they are commonly seen when friends, family, or acquaintances loan one another money. Because each of these situations is different, the parties are free to write their loan agreement in any manner they choose.
This includes using a variety of promissory note payment options to suit the needs of both parties. Promissory note payment options include the structure of the loan, repayment terms, and other information vital to enforcing the note. In addition to the amount of the loan, it is important to include very specific terms for repayment. Types of repayment include:
A lump sum payment option is the most straightforward type of repayment, as it specifies that the borrower will repay the entire amount of the loan with a single payment. A date is specified in the note, on which the full repayment is due, including interest if applicable.
Due on Demand
A due on demand note specifies that the borrower must repay the loan when the lender asks for it. The borrower is given a reasonable amount of time before such a demand may be made. In some cases, the lender is given the option of asking for payments before demanding the balance in full.
A lender can structure the promissory note with interest to calculate a monthly or annual interest rate, based on the amount remaining on the principal loan. When the borrower makes payments, the payment is applied to the accrued interest first, then the balance of the payment is applied to the principal.
Sample Promissory Note
Promissory notes may vary greatly in their wording. While it is acceptable for the parties to “wing it,” so to speak, there are sample promissory notes available from a variety of sources. When creating a promissory note, it is important for both parties to be sure each detail of the transaction is clearly stated in the contract. In addition, the borrower should read the contract carefully before signing. Promissory notes require only the signature of the borrower.
In order for a promissory note to be legally binding should a dispute arise, the language and provisions should be clearly understandable, as an ambiguous agreement may be deemed invalid by a court. The following sample promissory note may be used as a guide in creating an agreement.
Principal Amount: $_________
Borrower: ________________________, of _______________________________________ [address]
Lender: ________________________, of _______________________________________ [address]
1. FOR VALUE RECEIVED, Borrower promises to pay to Lender, at the address provided in writing to Borrower, the principal sum of $_______________, with interest payable on the unpaid principal balance at the rate of __________ percent per ________________[annum, or month] calculated ________________[monthly or yearly].
2. This Promissory Note will be repaid, including any interest accrued, on or before ___________________ [date].
3. Borrower may pay the outstanding balance of this note at any time, with no prepayment penalty, though any interest accrued to the date of repayment shall be due and payable. In the event Borrower is in default at the time of repayment, he shall remain liable for such penalties as may have been assessed through the date of repayment.
4. Should it be necessary for Lender to take legal action to enforce this Promissory Note, Borrower shall be responsible for paying all costs and expenses, including, Lender’s legal fees and costs, incurred in such enforcement. Costs of enforcement will be added to the outstanding principal balance, which shall become immediately due in full.
5. This Promissory Note shall be construed and governed by the laws of the state of _______________ [state in which the contract is made].
6. If any term or condition of this Promissory Note should be determined by a court of competent jurisdiction to be invalid or unenforceable, it is the parties’ intent that such term or condition be reduced in scope by the court only to the extent necessary to render the provision reasonable and enforceable, and that the remaining provisions of this Promissory Note will not be affected, invalidated, or impaired as a result.
Executed this ____ day of ____________ [month], ______ [year]
________________________________________ [signature of Borrower]
[Print or Type name of Borrower]
The sample promissory note above contains an agreement to repay the loan at the end of the term, with no periodic payments. If the parties wish for payments to be made by Borrower, the schedule of payments must be included in the Note.
Defaulting on a Promissory Note
A promissory note is a legally binding contract, the provisions of which usually spell out what acts, or failures to act, constitute a default. Failing to pay as agreed constitutes defaulting on a promissory note, as might any number of other deviations from the terms of the agreement. The note should also state specifically what will happen should the borrower default.
If the promissory note was secured by some type of personal or real property, defaulting on a promissory note is likely to result in the lender foreclosing on that property. If the property is not worth the amount due on the loan, the lender may file a lawsuit asking a judgement for the remaining balance. This is referred to as a “deficiency judgment.”
For an unsecured loan, the lender may file a civil lawsuit asking the court to order the borrower to pay the balance due immediately. In this situation, the borrower would also likely be ordered to pay the lender’s costs for collection attempts, court costs, and attorney’s fees. Even if the loan was not secured by something of value, the lender may place a lien on the borrower’s property.
A judgment by the court may result in the borrower’s wages and/or tax return being garnished, and the damage doesn’t end there. Defaulting on a promissory note can have a long-lasting effect on the borrower’s credit.
Is Defaulting on a Promissory Note a Crime
Defaulting on a promissory note is a civil matter, which is dealt with in civil court. If, however, the borrower falsified information on the loan application, or the note itself, it may be considered fraud, which is a crime.
Example of Promissory Note Effecting Jury Ruling
Eighty-year old Marion Levine lent money to her step-grandchildren from her third marriage, in 2000, having drawn up a promissory note which the grandchildren signed. The grandchildren paid on the note until 2005, when they suddenly stopped. Following Marion’s death in 2009, the executor of her estate realized that she had this outstanding loan.
The executor asked the borrowers to repay the debt, but they refused, claiming that Marion had forgiven the debt. Because there was no record of Marion having ever forgiven the debt, and she did carefully document the promissory note and payments received, her executor hired an attorney to enforce the note on behalf of the estate.
Having a signed personal promissory note had a definite effect on the outcome of the three-day trial. The judge ordered all of the borrowers to repay the remaining principal balance of the note, as well as legal fees expended to obtain the judgment.
Related Legal Terms and Issues
- Binding – Having power to bind or oblige; imposing an obligation.
- Civil Lawsuit – A lawsuit brought about in court when one person claims to have suffered a loss due to the actions of another person.
- Criminal Charge – A formal accusation by a prosecuting authority that an individual has committed a crime.
- Contract – An agreement between two or more parties in which a promise is made to do or provide something in return for a valuable benefit.
- Default – Failure to fulfill an obligation, or to appear in a court of law when summoned.
- Defendant – Control or advantage held by one entity over the commercial market in any specific geographical region.
- Jurisdiction – The legal authority to hear legal cases and make judgments; the geographical region of authority to enforce justice.
- Legally Binding – An agreement that is written and enforceable by law.