Promissory Note: What It Is, Different Types, and Pros and Cons

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.

In its simplest form, a promissory note might be a written promise to repay a family member. State or federal securities entities may regulate more complicated promissory notes.

Secured vs. Unsecured Promissory Notes

A promissory note can be secured or unsecured. A secured promissory note describes the collateral—typically property—that secures the debt or amount borrowed. For example, if the borrower owns property, the lender can use the car as collateral until the debt is repaid. If the borrower doesn't repay the loan, the promissory note permits the lender to take possession of the property.

An unsecured promissory note doesn't involve collateral. In this case, if the borrower doesn't repay the loan, the lender can try to use standard debt-collection procedures.

In either case, the lender holds the promissory note until the debt is repaid. Typically, those drafting a promissory note will consult with an attorney to make sure the note follows any state or federal laws around loans or investments.

What's Included in a Promissory Note?

A promissory note should include all the details about a loan and the repayment terms. In addition to the names of the borrower and the lender, a promissory note may also include:

• Name and address of borrower and lender
• Maturity date
• Sum borrowed
• Payment schedule
• Interest rate and how interest is calculated
• Prepayments process
• Overdue payment interest charged
• Default
• Waivers, amendments, and governing law for the promissory note

Types of Promissory Notes

In the United States, promissory notes are often used when getting a student loan, mortgage, or a loan from a friend or family member. Promissory notes are also sometimes issued to corporate clients.

Student Loan Promissory Notes

Many people sign their first promissory notes as part of getting a student loan. Private lenders typically require students to sign promissory notes for each loan taken out.

Some schools allow federal student loan borrowers to sign a one-time master promissory note, allowing receipt of multiple loans for up to 10 years if the school certifies the student's continued eligibility.

Student loan promissory notes outline the student borrower's rights and responsibilities and the loan's conditions and terms. By signing a master promissory note for federal student loans, the student promises to repay the loan amounts plus interest and fees to the U.S. Department of Education.

The master promissory note also includes the student's personal contact and employment information as well as the names and contact info for the student's references.

Mortgage Promissory Notes

Homeowners usually consider their mortgage an obligation to repay the money they borrowed to buy their residence. But actually, the signed mortgage promissory note represents a promise to repay the mortgage or loan, along with the repayment terms.

Typically, the promissory note includes:

• Amount you owe
• Mortgage loan's interest rate
• Ways your interest rate can change, if you have an Adjustable Rate Mortgage (ARM)
• Payment dates
• Repayment length of time
• Where you send payments
• Consequences of not making monthly mortgage payments

The promissory note describes the debt's amount, interest rate, and late fees. A lender holds the promissory note until the mortgage loan is paid off. Unlike the mortgage or deed of trust, the promissory note is not entered into county land records.

Corporate Credit Promissory Notes

Promissory notes are commonly used in business as a means of short-term financing. For example, when a company sells products but hasn't yet collected payments, cash may run low, leaving the company unable to pay creditors. The company may ask creditors to accept a promissory note to be exchanged for cash after the company collects its accounts receivables.

Or the company may ask the bank for cash in exchange for a promissory note. Promissory notes offer companies a credit source after exhausting other options, like corporate loans or bond issues. A note issued by a company in this situation is at a higher risk of default than, say, a corporate bond. The corporate promissory note's interest rate will likely provide a greater return than a bond from the same company, as high risk means higher potential returns.

These notes must be registered with the government in the state where sold and with the Securities and Exchange Commission (SEC).

If the note is not registered, the investor has to analyze whether the company is capable of servicing the debt. Companies in dire straits may hire high-commission brokers to push unregistered promissory notes on the public. If the company defaults, the investors' legal avenues may be somewhat limited.

Promissory Note Repayment

There are several different structures for repayment of a promissory note, but most involve repaying the principal plus interest. The interest rate can be fixed or variable and calculated daily, monthly, annually, or in another way. In some states, interest rates may be capped by state law. A certified accountant and attorney can advise you on the tax or legal implications of the promissory note's repayment schedule.

Here are various repayment approaches for a promissory note:

• Installment note: The most familiar repayment approach is through installments, with the borrower making regular payments; the repayment schedule and interest payments can vary.
• Simple note: For smaller loans, borrowers might arrange a lump-sum repayment on a specified date, meaning that's when you'll repay the whole amount listed in the promissory note.
• Open-ended note: This promissory note allows the borrower to draw on an operating or other loan over time and repay the draw plus interest by a specific date.
• Demand note: Sometimes, a promissory note may specify "on demand" repayment, meaning that the note must be repaid at the lender's request at any time.

Investing in Promissory Notes

Company or corporate promissory notes are rarely sold to the public. When they are, it is usually at the behest of a struggling company working through unscrupulous brokers who are willing to sell promissory notes that the company may not be able to honor.

Alternatively, the promissory note may be part of a scam sold by life insurance agents or online or out-of-state investment advisors. Some sellers may know nothing about the investments' true origins—the promissory notes may be for companies that don't exist. Promissory notes promising "low risk, high yield" investments may lead to a type of fraud, according to the SEC.

Before investing in promissory notes, ensure all of the following are true:

• The person selling the promissory notes is licensed to sell securities 
• The company offering promissory notes is legitimate and can repay debts
• Promissory notes are properly registered by the SEC, state securities regulator, or legally exempt from registration
• If guaranteed or insured by a foreign insurance company, contact your state department of insurance to make sure the company can do business in the U.S.

Investing in promissory notes involves risk. These promissory notes are only offered to corporate or sophisticated investors who can handle the risks and have the money needed to buy a note. To help minimize these risks, an investor must register the promissory note or have it notarized so that the obligation is publicly recorded and legal.

A Brief History of Promissory Notes

Promissory notes have had an interesting history. At times, they have circulated as a form of alternate currency, free of government control. In some places, the official currency is a form of promissory note called a demand note (one with no stated maturity date or fixed term, allowing the lender to decide when to demand payment).

Promissory notes and bills of exchange are governed by the 1930 Geneva Convention of Uniform Law on Bills of Exchange and Promissory Notes. Its rules stipulate that the term "promissory note" should be inserted in the instrument's body and contain an unconditional promise to pay.

The Bottom Line

A promissory note is a written promise by one party to make a payment of money at a date in the future. Although potentially issued by financial institutions, other organizations or individuals can use promissory notes to confirm the agreed terms of a loan. In short, a promissory note allows anyone to act as a lender. However, the average investor should be wary of and heavily research any sales pitches for promissory notes as an investment.