Promissory note: What it is and how it works
A promissory note, sometimes called a promise-to-pay agreement, is a written promise in which one party agrees to repay another party. Borrowers who take out personal loans, student loans and mortgages may need to sign a promissory note. And businesses sometimes use these documents to raise funds.
But when does someone need a promissory note and how do they work?
Key takeaways
- A promissory note typically states that a borrower promises to repay a lender a certain amount of money by a specific date.
- These notes are legally binding and may include loan terms—like the principal amount, interest rate and payment schedule.
- Both parties are typically required to sign the note, but exact requirements may vary.
How does a promissory note work?
A promissory note is a written promise to pay back money. These legally binding agreements typically include debt repayment terms—like payment schedules and interest rates.
A borrower is expected to follow the repayment terms outlined in the promissory note. If a borrower violates the terms of a valid promissory note, the lender may have the right to recover its money.
What does a promissory note contain?
Keep in mind that requirements could differ from one state to the next. But promissory notes typically include:
- Names, addresses and signatures of the borrower and lender
- Principal loan amount
- Interest rate
- Lump sum or installment payment amount
- Payment due date and schedule
- Late fees or other penalties
What makes a promissory note invalid?
Promissory notes are legally binding, but if a note becomes invalid, it may not be enforceable.
A promissory note could become invalid if:
- It isn’t signed by both parties.
- The note violates laws.
- One party tries to change the terms of the agreement without notifying the other party.
- An unauthorized person, like the borrower’s relative, signs the note.
Borrowers and lenders may have to go to court if a promissory note becomes invalid.
Types of promissory notes
Borrowers may need to sign promissory notes for a variety of debt agreements. These documents could offer borrowers and lenders some protections if either party doesn’t follow the outlined terms.
Promissory notes for personal loans
If someone lends money to a friend or family member, a valid promissory note can make the agreement legally binding and help protect both parties’ interests.
Student loan promissory notes
Borrowers may sign a promissory note when they take out private or federal student loans. Federal student loan borrowers may sign a Master Promissory Note (MPN) that can be applied to multiple loans.
By signing the MPN, a student agrees to repay all loans according to the terms and conditions of the MPN. Federal student loan MPNs are currently valid for up to 10 years.
Promissory notes for investors
Businesses sometimes use promissory notes for short-term financing. These notes can carry investment risks and may need to be registered with state or federal agencies—like the Securities and Exchange Commission.
Promissory note vs. mortgage: What’s the difference?
When someone buys a home with either a mortgage or deed of trust, they may need to sign a promissory note.
What a promissory note means during the homebuying process
The promissory note is a written agreement that outlines the mortgage terms and conditions, and it’s typically signed at closing. It may include the loan amount, loan term, payment amount, due date and more.
If a borrower doesn’t comply with the promissory note terms, the lender may have the right to foreclose the property.
What a mortgage means during the homebuying process
A mortgage refers to the loan a homebuyer uses to purchase a property. The purchased property is typically used as collateral for this type of secured loan. Homebuyers technically don’t own their homes until the mortgage is repaid in full. But as payments are made on the mortgage, a homeowner’s equity grows.
Promissory notes in a nutshell
A promissory note is a legally binding promise to repay a debt. These agreements could be used for personal loans, student loans, mortgages and more.
Promissory note laws vary by state, but they typically include the loan amount, loan terms and signatures from both the lending and borrowing party. If the promissory note doesn’t meet certain requirements, it may become invalid.
Interested in learning more about loans and lines of credit? Check out this guide on different types of debt.