A promissory note is a written promise to pay a specific amount of money to someone at a particular time, or “on demand.” Promissory notes are common when borrowing money from a bank or financing a big purchase, but they also for personal finance scenarios such as loaning someone else money.
A promissory note sets out the terms of the loan, including the loan amount, interest rates and when payments are due. A written promissory note is easier to enforce in court than a verbal agreement.
Common Uses for Promissory Notes
Promissory notes are used for mortgages, car loans, lines of credit, home equity loans, loans to small businesses and entrepreneurs, student loans and personal loans. Promissory notes also can be used for loans to family or friends.
It may seem awkward to ask your brother or best friend to sign a legal document, but a promissory note protects both you and your relationship. It clarifies your expectations and shows that you are serious about being paid back.
What to Include in a Promissory Note
A promissory note lays out all the terms of the loan. It’s much more than a simple “I owe you $1,000.” A promissory note should include:
- The names and addresses of the lender and the borrower
- The amount of money being loaned
- The interest rate
- The collateral or “security” being used, if any
- The amount of the payments and when they are due
- Penalties for late payments, including late fees and/or repossessing the collateral
- The signatures of the borrower and the lender
To make sure you include all the necessary information and the right legal language, it’s helpful to use a promissory note template.
Negotiating a Promissory Note
If you are lending someone money, a promissory note helps protect your investment and gives you some recourse if the borrower doesn’t pay. One of the first issues to consider is whether the note will be secured or unsecured. A secured note uses real estate or personal property as collateral. If the borrower doesn’t pay, you can take the property. An unsecured note relies on the borrower’s promise to pay. If the borrower doesn’t pay you, your only recourse is to go to court.
Secured notes are common for purchases of large assets such as houses, cars or boats, or for loans involving large amounts of money. Unsecured notes are more common for smaller amounts. Because unsecured loans are riskier for the lender, they often carry a higher interest rate.
Other issues to consider include:
- How good is the borrower’s credit? A credit check will show whether a borrower pays their bills on time. Based on the credit check, you can decide not to loan someone money, to require a cosigner or to negotiate a higher interest rate or steeper penalties for nonpayment.
- Should the loan be amortized or repaid in a lump sum? An amortized loan is paid in installments of principal and interest over a period of time. A lump sum loan is repaid all at once. Amortization is common for large loans, while lump sum repayments work well for small amounts or situations where the borrower has only a short-term need for the money.
As the lender, your aim is to protect yourself and limit your risks.
What to Do If You’re Paid Late (or Not at All)
Ideally, your borrower will make payments on time, but that doesn’t always happen. If your borrower misses a payment, the first thing to do is to send a bill or email reminding them that the payment is late. Often that’s all you need to do.
If borrowers still don’t pay, try talking to them. Sometimes borrowers will pay if prompted personally, or you may find out why the borrower is late with their payment. This can give you a chance to negotiate a way to get paid, including waiving late fees or accepting partial payment in exchange for getting paid quickly. Or, if the loan is secured, you can proceed with taking the property that serves as collateral for the loan.
If the loan is unsecured and the borrower still does not pay, you can send the debt to a collection agency. The collection agency will take over the debt collection process for you and will charge a percentage of the amount collected as a fee. If all else fails, you can take your borrower to court.
A promissory note puts the terms of a loan in writing, minimizing the chance of any misunderstanding between you and the people you loan money to. And, if your borrower doesn’t pay, the promissory note can help you pursue available legal remedies.