What Is a Promissory Note?
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Different Types of Promissory Notes
A promissory note is a financial instrument that is used when a person promises to pay another party a specific amount of money, either at a specified date in the future or whenever the payee requires it. Some also call it by other terms, such as an IOU or a loan agreement, and sometimes simply just a note[1].
There are various types of promissory notes, and each of them is used for a specific purpose. Here are some common examples of promissory notes.
Student Loan Promissory Notes
University students who want to take out a loan to cover the costs of their education have to sign a promissory note.
A private lending company requires college students to sign a promissory note when applying for a student loan. For student loans offered by the federal government, there is only a master promissory note that students have to sign.
Promissory notes related to student loans state the borrower’s responsibilities and rights. The borrower’s personal contact information and their personal references must also be included in the promissory note. This written document also outlines the terms and conditions of the student loan.
Real Estate Promissory Notes
Taking out a mortgage also requires the borrower to sign a promissory note, which serves as proof that the borrower has the willingness to pay back what they owe[2]. Promissory notes are used to sell houses and secure home loans, which are a form of installment loans.
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Mortgage promissory notes outline the amount of the loan, the interest rate, and repayment terms. The lender keeps the promissory note until the borrower makes full payment of the home loan.
There is also what many lenders call a vendor take-back mortgage. This home loan is unique because the owner/seller of the house becomes the lender. It is a great way to purchase a house if the buyer does not qualify for a traditional mortgage. The buyer can borrow an amount that can cover a portion of the down payment, closing fees, and even a considerable part of the mortgage.
RELATED: Why Seller Financing Makes Sense
The collateral on this kind of mortgage will be the deed of the house. If the borrower fails to make payments, the deed will revert to the seller. The borrower of the home loan signs a promissory note to show their willingness to pay the property’s price and interest.
Business Promissory Notes
Most short-term business financing also requires the borrower to sign a promissory note. For instance, if a business has yet to collect the accounts receivable for goods or services sold, the business owner can request a promissory note that can be converted to cash after the payments for the sold goods or services are claimed.
A business can also resort to using promissory notes if it has already used up bonds and corporate loans. However, a buyer or an investor of promissory notes must register them at the state level so the company that issues the notes can meet the promises enclosed therein.
RELATED: 13 Things You May Not Have Known About Note Investing
Investors in promissory notes can also obtain an insurance policy on the life of the issuer. This means that in the event of the death of the issuer of the promissory note, an investor can assume ownership on a portion of the company, or they can take a part of the company’s assets.
Sophisticated investors and corporations are the ones typically offered these promissory notes. They can sell the notes like securities to other investors[3].
Takeaways
A promissory note is a written promise issued by a person or a business to another party to show their willingness to fulfill a specific financial obligation. It is a legally binding document stating that a sum of money owed will be paid by one party to another on-demand or at a future date. Promissory notes are used in student loans, real estate, and corporate credit.
References
- Sember, B. (2016). What is a Promissory Note? Legal Zoom. Retrieved from
https://www.legalzoom.com/articles/what-is-a-promissory-note - Loftsgordon, A. (n.d). What’s the Difference Between a Mortgage and a Promissory Note? NOLO. Retrieved from https://www.nolo.com/legal-encyclopedia/whats-the-difference-between-mortgage-promissory-note.html
- INC. (2000). Promissory Notes. Retrieved from https://www.inc.com/articles/2000/04/19197.html
