How a Promissory Note Works: 4 Types of Promissory Notes

A promissory note is a written agreement in which one party states the intention to borrow a specific amount of money from another party, and then pay back that loan by a certain date or time. Promissory notes typically require signatures from the borrower (or payor) and lender (or payee), making them legally binding documents. Lending and borrowing parties can choose to have a notary public notarize promissory notes as an extra legal safety net.

Financial institutions such as banks and lenders often use promissory notes when issuing real estate mortgage loans or student loans. Companies or individuals also use promissory notes when issuing or taking on personal loans or corporate loans. Two private individuals may also use a promissory note to make a loan between them more legally binding without going through a bank.

Any two parties who wish to enter into a loan agreement can draft a promissory note, which states the intention of the lender to loan the borrower a specific amount of money, as well as the terms and conditions for repayment of that loan, to which both parties have agreed. These terms and conditions typically include the principal amount of money, the interest rate, the date of issuance, the repayment schedule, the maturity date or deadline for repayment, and any consequences if the borrower defaults on the loan.

A promissory note is more legally enforceable than an informal IOU and slightly less formal than a loan contract. Like loan contracts, promissory notes may contain a clause granting the borrower security in the asset in the event that the borrower defaults on the loan. However, a promissory note is rarely sufficient to grant the lender a lien on an asset if the borrower defaults on their loan, as a loan contract would do.

There are many different types of promissory notes with varying degrees of formality that parties can use in a variety of situations. Here is an overview of some of the most common types of promissory notes.

1. 1. Commercial promissory notes: A commercial promissory note is a formal type of promissory note that institutions like credit unions or banks typically issue to borrowers. Commercial lenders might use these for auto loans, personal loans, or business loans to private individuals.
2. 2. Real estate promissory notes: A bank may issue a real estate promissory note at the beginning of a mortgage for a real estate home loan. This is especially useful if the lending party is a private individual rather than a bank. These types of promissory notes indicate that the home is collateral for the loan, and the creditor or issuer can theoretically place a lien on the property if the borrower cannot pay by a specific date or defaults on the loan.
3. 3. Student loan promissory notes: When a student takes out a loan for student financial aid for their undergraduate or graduate schooling, they typically sign a promissory note to formalize the loan. The promissory note agreement often stipulates that interest does not begin to accrue until after the student graduates. Students can often sign a master promissory note for the entirety of their schooling, which they don’t need to re-sign each year they take out a loan for school.
4. 4. Informal promissory notes: An informal promissory note, also called a personal promissory note, typically comes into play for a loan between two individuals such as friends or family members. It is a written promise between the payor and payee that a sum of money will be repaid in a certain period of time, and might not include as many repayment terms as other more formal promissory notes.

In many cases, the life of a loan begins when a borrower and lender sign a promissory note, so the document needs to state certain terms and conditions very clearly. Here are eight things that a legally binding promissory note will typically contain.

1. 1. Principal debt: The principal debt is the total loan amount the payor is borrowing from the lender, and promises to pay back over the life of the loan.
2. 2. Date of issuance: The date of issuance on a promissory note states the date and time the note was issued and the loan begins. This also begins the time frame for repayment.
3. 3. Maturity date: The maturity date on a promissory note states the final due date by which the borrower needs to pay back the entirety of the loan.
4. 4. Repayment schedule: Promissory notes typically indicate the incremental repayment schedule the borrower must follow. For example, some loans may be repaid in installments like monthly payments. In other instances, a borrower may make a payment in a lump sum at the maturity date.
5. 5. Interest rate: A promissory note typically includes the amount of interest that a borrower will agree to pay the lender as a fee for granting them the loan. Interest may be charged as an incremental fixed rate percentage of the unpaid balance of the loan, or a variable rate that changes with time.
6. 6. Amount to be repaid: A promissory note may include the total amount of the loan to be repaid, which includes the principal debt as well as any interest payments accrued over time.
7. 7. Collateral: The lender may list any possessions or property to be used as collateral in the event that the lender defaults on the loan. This gives the lender security in the exchange.
8. 8. Signatures: A promissory note should include the signatures of both parties to confirm the terms of the agreement and make the note legally binding.

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