Promissory Note

A promissory note is a written promise by one party (the maker or promisor) to pay a specified sum to another party (the payee) either on demand or at a set future date. It is more formal than an IOU but less complex than a full loan agreement, and it can be used by individuals, companies, or financial institutions.

Key takeaways

• A promissory note records a borrower’s promise to repay a specified amount, often including interest and a repayment schedule.
• Notes can be secured (backed by collateral) or unsecured. Secured notes give the lender a claim on specified assets if the borrower defaults.
• Common uses include student loans, mortgages, and short-term corporate financing.
• Promissory notes can present investment opportunities but carry fraud and default risks; due diligence is essential.

How promissory notes work

• Parties: the promisor/maker (who promises to pay) and the promisee/payee (who is owed money).
• Form and enforceability: the note should state the amount, repayment terms, signatures, and governing law. More complex offerings may be subject to securities regulation.
• Possession: the payee typically holds the original note until the debt is paid; once fully repaid the note should be canceled and returned.

Secured vs. unsecured

• Secured note: backed by collateral (e.g., real estate). If the borrower defaults, the lender can seek the collateral.
• Unsecured note: no collateral; lender relies on collection procedures and legal remedies.
• Legal counsel is commonly used to ensure compliance with state and federal laws.

Essential components of a promissory note

A complete note typically includes:
* Names and addresses of borrower and lender
Principal amount and maturity date
Interest rate and method of calculation
Payment schedule (installments or single payment)
Terms for prepayment and late payments
Default provisions and remedies
Any waivers, amendment procedures, and the governing law
* Issuer’s signature (and often notarization for added enforceability)

Common types

Student loan notes
* Private student loans and federal master promissory notes (MPNs) document student obligations, borrower rights, and contact/employment information.

Mortgage promissory notes
* The mortgage note is the borrower’s promise to repay a home loan and details amount owed, interest rate (and ARM provisions if applicable), payment dates, loan term, and consequences of default. Unlike the mortgage/deed of trust, the note itself is not typically recorded in land records.

Corporate promissory notes
* Businesses use notes for short-term liquidity needs (e.g., bridging accounts receivable). Corporate notes can offer higher yields but carry higher default risk and may require registration with securities regulators if sold to investors. Unregistered offerings and aggressive sales tactics have been associated with fraud.

Repayment structures

• Installment note: regular periodic payments of principal and interest.
• Lump-sum (simple) note: entire principal and interest due on a specified date.
• Open-ended note: borrower can draw funds over time and repay by an agreed date.
• Demand note: payable upon the lender’s request at any time.

Investing considerations and risks

Promissory notes can be investment vehicles but pose unique risks:
Red flags
* High-return, low-risk claims
Sellers who are unlicensed or use high-pressure tactics
Notes lacking proper registration or exemptions when required
Due diligence checklist
* Verify the issuer’s legitimacy and financial ability to repay.
Confirm the seller is licensed to sell securities (when applicable).
Check registration with the SEC or state regulators, or confirm a valid exemption.
If guaranteed by an insurer, verify that insurer’s authorization to operate in the relevant jurisdiction.
Consider notarization or public recording of the obligation to improve enforceability.
Note: many promissory note investments are limited to sophisticated or accredited investors due to risk.

Legal and historical context

• Promissory notes and bills of exchange are governed internationally by conventions such as the 1930 Geneva Convention, which requires that an instrument clearly state it is a promissory note and include an unconditional promise to pay.
• Historically, promissory notes have sometimes circulated like currency (e.g., demand notes), reflecting their longstanding role in finance.

Pros and cons

Pros
* Flexible tool for documenting loans between parties (individuals, businesses, institutions).
Can enable borrowing when traditional bank financing is unavailable.
Cons
* Risk of default—lenders may have limited recovery methods, especially with unsecured notes.
Possibility of fraud or unregistered securities offerings when notes are sold to the public.
* Legal disputes over terms or enforcement can be costly.

Example

A startup low on cash issues a short-term promissory note to a supplier promising to repay once accounts receivable are collected. The note specifies the principal, interest rate, repayment date tied to receivables collection, and remedies on default.

Conclusion

A promissory note is a straightforward written promise to pay that can be used in many lending contexts. It must clearly state terms and legal remedies, and both parties should perform due diligence and consider legal or tax advice. Investors should be particularly cautious with corporate notes and verify registration and the issuer’s ability to pay.