Promissory Notes: What They Are and When to Use Them

Borrowing and lending money are something most of us do at some point in our lives. Whether it’s through a formal loan with a bank or among friends or family, a record of the loan helps make sure that all the lender is eventually repaid.

A verbal agreement isn’t enough if large sums of money are exchanged informally, like when loaning your sibling some cash for a car or helping a friend out with rent. Instead, a legal document like a promissory note can keep both parties accountable for their roles in the deal.

The lender doesn’t have to sign the promissory note, but the borrower does because it’s the written record that they are promising to pay the money back. Since a promissory note is legally enforceable, it’s important that all of the details are correct before the borrower signs it. 

Even if the loan is among friends or relatives, working with an attorney is the best course. They use legal document drafting software to ensure that relevant details are in the contract and contain the necessary signatures to make the promissory note binding.

When are promissory notes used?

Any kind of financial lending can use promissory notes, either as standalone documents or as part of the paperwork needed when borrowing large sums of money for big ticket items. Both personal lending and business transactions use promissory notes to provide the lender with legal protections.

Some of the most common uses for promissory notes are:

• Real estate. As part of the mortgage paperwork for a home or business investment, the buyer signs promissory notes to denote their obligation in paying back the money they’ve used for the property.
• Student loans. When someone takes out a higher education loan, they complete promissory notes as a promise to repay those funds. Federal loans often allow students to sign a master promissory, which covers any loans taken out within the next 10 years that the student stays enrolled. 
• Business equipment purchases. Any loan a business takes out to fund necessary operating equipment comes with a promissory loan. Like personal loans, these notes state that the business is responsible for paying back the full amount by a certain date.
• Working capital. Some businesses may take out loans to support their operations, particularly in off-season or when starting a new company. The money acts as funding for essential day-to-day spending until income can replace it. These loans have their own promissory notes.

Many people choose not to use promissory notes when loaning money to friends and family, even for a lot of cash. However, this is a risky move and there’s no guarantee you’ll see that money again. And without a promissory note, there’s nothing you can do if they don’t repay you. 

For small amounts, a note is usually not necessary. But for money that you’d miss if you didn’t get it back, a promissory note solves the issue well.

Types of promissory notes

Depending on the type of loan, you need different types of promissory notes to set the repayment terms for the borrower.

Simple

This is the most basic type of promissory note and is generally used for smaller loan amounts with a single borrower. If two individuals are exchanging money, all they need is a simple note. The details included in a simple promissory note can be as stripped down as the amount, the terms of the repayment, the payment schedule, and the names of those involved.

Open-ended

An open-ended promissory is more like a line of credit than a traditional loan. Borrowers only receive a portion of the full amount upfront, but they can take additional money later if they need more while paying back the original amount borrowed. This can be easier to manage than taking out multiple loans with different promissory notes.

Master

If a borrower needs multiple loans, they and the lender can use a master promissory note as an ongoing agreement. This can cover several loans between the same parties for a given amount of time, like individual student loans. 

Secured

A secured promissory note typically comes with better interest rates than yhe other kinds because something of value needs to be put down as collateral as part of the loan. If the borrower fails to repay the money, this secured note allows the lender to take possession of the collateral in lieu of the payment balance.

Unsecured

Unsecured promissory notes don’t require the borrower to put down any collateral, but there are still legal options for the lender should the borrower not make their repayments. 

These promissory notes are common in real estate transactions, as the mortgage is used to secure the loan, rather than any additional collateral. If the mortgage isn’t repaid, a lien can be put on the property that allows the lender to foreclose on it and recoup their money.

Information included in a promissory note

The basic elements of a contract should also be included in a promissory note. Additional details may be needed depending on the type of note, but at minimum, a promissory note should contain:

• Contact details of the lender and borrower. Along with the date of signature, the first section of a promissory note outlines who is borrowing the money and who is lending the money.
• Total loan amount. The lender and borrowers must agree on the total amount of money being exchanged. 
• Maturity date. This is when the promissory note ends; the full amount should be repaid by this date. Some promissory notes may also list this as the “due date”.
• Fees, interest details, and penalties. Fees associated with creating the promissory note are listed here, along with interest rate details and any penalties to be applied if the borrower doesn’t fulfill the payment agreement.
• Terms of the repayment. These provide all of the information about how exactly the borrower will repay the money. Most promissory notes for larger sums are in installments, either weekly, monthly, or quarterly. Smaller amounts may be due as a lump sum by a fixed date.
• Repayments start date. This date is important for the borrower to know because not all repayments begin as soon as the promissory note is signed.
• Governing law or jurisdiction over the note. Where the promissory note is signed is very important. If the lender needs to take legal action against the borrower, this information outlines which geographic area – or governing body – is responsible for overseeing the legal proceedings.
• Borrower’s signature. Only the borrower signs the promissory note, as it’s their promise to repay the money.

If you use a secured promissory note, you must include details on the collateral. Master promissory notes also have more intricate information about how long the note is good and which type of loan it covers.

How are promissory notes repaid?

Much like a traditional loan agreement, borrowers can repay in several ways. Along with lump sum and installment, you also have due on demand and balloon payments.

• Due on demand payments. If there’s no specific payment information listed in a promissory note, the lender could demand full repayment at any time. This is never advised for large loans, but can be common in small, informal arrangements.
• Balloon payments. Some lenders may ask borrowers to pay a section of their loan through regular monthly installments, followed by a larger, final payment to close out the promissory note by a particular date.

Thanks so much - IOU!

Promissory notes may feel like an unnecessary step, especially if you’re lending or borrowing a small amount or it’s just between friends. But keeping everyone legally protected is important, so put it on paper with the help of legal documentation drafting tools that make exchanging money quick and simple.

Trying to sign a promissory note with someone far away or simply looking for an easier way to digitize the process? With e-filing platforms, completing legal documents has never been easier.