In every lending transaction, from a small personal loan to a home loan, the borrower must promise to pay back the amount they borrowed. They make this promise not by giving their word, but by signing a promissory note.
Promissory notes are a simple but vital component of borrowing money. These legal documents are issued by the lender to secure their right to be repaid. Read on to learn more about what promissory notes are, how they work, and how to create your own.
This blog post is offered for general information purposes only. It does not constitute, and is not a substitute for, legal advice.
What is a promissory note?
A promissory note is a written agreement between a borrower and a lender saying that the borrower will pay back the amount borrowed plus interest. The promissory note is issued by the lender and is signed by the borrower (but not the lender). It is considered a contract, and signing it legally obligates the borrower to pay back the amount borrowed, plus any interest, as defined in the promissory note.
When do you need to use a promissory note?
A promissory note is essential in any transaction where money is being lent by a person, bank, company, or other organization to another entity. This document is a contract that protects the lender from the risk of the borrower not paying the full amount agreed to by both parties.
Are promissory notes required for family loans?
A promissory note is like an IOU. However, with an informal IOU between friends or family, there is limited—or no—legal recourse if the borrower does not repay the amount borrowed. For small amounts of money that the lender will not miss, a promissory note is probably not necessary.
However, for any transaction where the lender expects the full amount to be repaid, a promissory note may be a good idea. This may seem like an overly formal way to lend money to loved ones, but in circ*mstances where repayment is not optional, it provides all parties with a legal framework for how to resolve any unpaid debt.
Types of promissory notes
There are several types of promissory notes. The features that differ between types of notes include how and whether the promissory note is secured, detail of repayment requirements, and terms of repayment.
Simple promissory note
As the name suggests, this is a promissory note with only the basics included: the amount owed, the terms, and payment schedule. Simple promissory notes are more common for smaller loans with a single borrower.
Secured promissory note
A secured promissory note is an agreement where the borrower puts something of value up as collateral to safeguard the value of the loan. In the event the borrower is unable to make payments and defaults on the loan, a secured promissory note empowers the lender to take possession of the collateral in lieu of payment.
Unsecured promissory note
An unsecured promissory note does not require the borrower to provide any collateral in order to receive the loan. However, an unsecured promissory note is still a contract, and as such the lender has legal options to collect any overdue payments.
Unsecured promissory notes are common in real estate transactions, because the mechanism for securing the loan is the mortgage, rather than separate collateral associated with the promissory note. While they are very similar, the unsecured promissory note only represents the borrower’s promise to pay the full amount plus interest, while a mortgage puts a lien on the real estate that allows the lender to foreclose on it in the case of nonpayment.
Master promissory note
A master promissory note is an ongoing agreement between the borrower and the lender. Similar to a master services agreement, a master promissory note allows both parties to agree to a set of terms that will govern multiple loan agreements. This type of promissory note is commonly used for student loans, where multiple loans are expected to be taken out over a relatively short period of time.
Open-ended promissory note
An open-ended promissory note is similar to a line of credit. Rather than receiving the full amount of funds immediately, the borrower only receives a portion and pays that back over the period of time agreed to in the promissory note. This allows the borrower to draw additional funds later that are governed by the same promissory note without having to take more than they initially need.
Demand promissory note
A demand promissory note foregoes details about multiple payments in favor of a single payment being due upon demand of the lender. These types of promissory notes generally have requirements for advance notice of intent to collect.
Balloon promissory note
A balloon promissory note has all the usual repayment requirement details, with one important distinction. Instead of an even amount of payments over the term of the loan, smaller payments are made at first and a single large payment is made at the end. These can be appealing for small business borrowers because it allows them more runway for building revenue before needing to pay off the loan.
How promissory notes are used in business
Promissory notes are commonly used in multiple business contexts. For example:
- Land, building or construction purchases
- Car or truck purchases
- Equipment purchases
- Working capital
- Employee loans
- Loans between businesses
What is included in a promissory note?
At its most basic, a promissory note is simply a contract. As such, it needs to have certain sections to ensure all parties are fully protected and treated fairly. Common sections of a promissory note include:
- Contact information for the borrower and the lender
- Total amount lent
- Terms of repayment, including interest rate and repayment schedule
- Date of the first payment
- Maturity date
- Fees, taxes, and other payments
- Date and location of where the promissory note was issued
- Borrower’s signature (the lender does not sign the promissory note)
This is not an exhaustive list of sections that may be included; depending on the type of loan and the parties involved, it can be customized further.
Promissory note template
The Department of Housing and Urban Development has a promissory note template for use in real estate transactions. This template can serve as the basis for additional types of transactions. Once completed, it can be uploaded to an electronic signature system to be signed quickly, easily, and securely.
Sign promissory notes quickly and easily with DocuSign eSignature
Promissory notes are one example of the many routine legal documents that can be signed using DocuSign eSignature.
Our guide, How Does eSignature Work?, has everything you need to know about signing documents electronically.
