A promissory note is a legal document that illustrates a written promise between two parties—typically a borrower (the note’s “payee”) and a lender (the note’s “issuer” or “maker”)—that states the terms and conditions of a financing agreement. It defines elements such as the principal loan amount, interest rate, maturity date, repayment schedule, collateral requirements, and default and late payment terms. Essentially, it acts as acknowledgment of the specified lending terms and is legally enforceable when properly signed by both parties.
Key Takeaways:
- It is a debt instrument that reflects a promise between two parties partaking in a financing transaction.
- It can be used by any party partaking in a financing transaction and is not specific to banks or other traditional lenders.
- It essentially acts as a legally binding “IOU.”
- The legal enforceability of a promissory note can include consequences such as asset seizure, legal fees, and impact on your credit score.
How Does a Promissory Note Work?
A promissory note is commonly prepared by a legal professional or, oftentimes, can be drafted by the issuer themselves. It’s worth noting that while a promissory note is most commonly issued by financial institutions, it can also be used by individuals or companies lending money to a borrower in any capacity.
When seeking financing, it will likely be one of many paperwork requirements associated with loan closing. And at closing, you’ll be expected to review the terms set forth in the note and provide your signature in acknowledgment. Commonly, a promissory note is also signed by a notary public alongside the issuer’s and borrower’s signatures. Once the document is executed, it’s considered to be a legally binding contract and terms must be followed by the borrower.
Common Elements of a Promissory Note
The structure and language of a promissory note can vary depending on the lender and the type of financing you seek. However, there are common elements associated with most promissory notes, which typically include the following:
- Names and addresses of both parties
- Principal loan amount
- Applicable interest rate
- Repayment schedule
- Maturity date
- Collateral requirements
- Default and late payment terms
Types of Promissory Notes
There are two main types of promissory notes, which are categorized as either secured or unsecured based on the type of financing you need.
- Secured promissory note includes a form of collateral that’s used to secure the loan in the event of default. This can include collateral types such as property, equipment, and inventory.
- Unsecured promissory note allows financing to be sought with no collateral. In the event of default, the lender must seek other debt collection methods.
Repayment Structures of Promissory Notes
There are different types of repayment structures included in promissory notes that can be used based on the type of financing you choose.
- Installment promissory note: This is the most common and means that the expected repayment structure will take place in installments, typically monthly, until the end of the loan term.
- Simple promissory note: More commonly used with smaller loans, a simple note allows the borrower to repay the entirety of the loan at once and make a lump sum payment at the end of the loan term or other specified date.
- Open-ended promissory note: This form of repayment is usually associated with revolving credit facilities, in which the borrower can draw on the loan during the draw period and repay the balance plus interest over time until the maturity date.
- Demand promissory note: With this, the lender can “demand” that the borrower immediately repay the outstanding loan balance at any given time, without the need for a set repayment schedule.
- Investment promissory note: This is a type of repayment structure that involves a company borrowing money from an investor, and the investor is expected to receive a set amount of period income in exchange.
- Convertible promissory note: This is commonly used by investors and allows a borrower to convert debt into equity, which usually takes place at a later date once the company has achieved sufficient growth.
Promissory Note Examples
There are a variety of instances in which a promissory note may be used, and the repayment structure, and terms will vary depending on the lender and applicable note type. Here are some scenarios in which a promissory note might be used for different financing types.
Getting a Small Business Loan
A small business owner may seek funding from a local bank to fund various renovations of their property. They request a loan of $50,000, with a repayment term of five years. The note would include details such as the principal amount and the agreed-upon interest rate, including whether a fixed rate or variable rate is used. It would also reference the repayment schedule.
With this loan, it’s likely to be an installment payment schedule, in which the borrower makes equal monthly principal and interest payments during the five-year term. Lastly, the note would outline items such as collateral, the consequences of default, late fees, or prepayment penalties.
Borrowing Money from Friends & Family
If someone were to raise money for their business from friends and family, a promissory note should be issued, even though this is a less formal financing route. For a business owner seeking capital to help cover startup costs, a simple promissory note may be drafted in which the borrower would repay friends and family members with a lump sum payment once they have enough cash flow to provide a return on investment (ROI). The note would include details as to the principal loan amount, the repayment terms, and the assigned rate of interest.
Working With Venture Capitalists
If a startup needing funds to fuel its growth potential sought to raise venture capital funding, a convertible note can be used as an alternative to debt-based financing. Essentially, the business can provide the investors with equity in the business at a later date, after the debt has been converted.
It’s uncommon for a borrower to prepare a promissory note, which is typically drafted by a legal professional or an issuer with experience in facilitating loan documentation.
You can often find free templates from legal resources. For instance, RocketLawyer offers free promissory note templates specific to your state and can customize the document based on the information you provide.
However, it’s worth working with a legal professional to review and ensure that the document encompasses the necessary details and that all terms are outlined clearly.
Pros & Cons of a Promissory Note
| PROS | CONS |
|---|---|
| Protects both a borrower and lender entering into a financing agreement | Doesn’t mitigate all risk when it comes to loan default |
| Is legally enforceable when compared with an IOU | Must be drafted properly to be enforceable |
| Has definitive terms and conditions that provide clear expectations to the borrower | Can be difficult to sell if the issuer needs to liquidate assets |
When a Promissory Note Is Used
It’s common for most loan types to use a promissory note. Not only is it applicable to business loans, but it also includes other forms of financing—such as student loans, mortgages, personal loans, and car loans. If you plan to borrow a large amount of money, a promissory note will act as a legal enforcement that the funds must be repaid to the lender.
Essentially, it protects both parties. It protects the
- borrower in the sense that terms and conditions are outlined clearly and that any consequences—such as fees—are clearly stated upfront before entering into an agreement
- lender in that they will have a written promise that they will be repaid by the borrower or be allowed to recoup their losses in the event of default
Common Mistakes to Avoid When Signing a Promissory Note
If you’re in the process of getting a small business loan, it’s likely that you’ll be expected to sign a promissory note upon loan closing. As with any form of legal documentation, it’s important to maintain accurate and complete records. However, mistakes do happen, but there are actions you can take to avoid such instances.
