What is a Promissory Note and How to Write One

Think of a promissory note as a formal document, promising to pay someone a certain amount within a certain period of time.

Promissory notes are used to make borrowers legally accountable for paying back the borrowed sum of money along with interest and late payment fees, if there are any.

You may have already signed several of these notes when taking on loans, without knowing what they actually are or how to create one when needed.

Promissory notes are known by various other names such as; IOU, loan agreement, prom note and etc, and are used by both individuals and businesses alike.

When are promissory notes used?

Promissory notes are typically used in mortgage loans, student loans, car loans, business loans and even in personal loans between family and friends.

A promissory note is all you need in a loan relationship between two individuals or businesses but in some cases such as when applying for a home loan, a mortgage is required as well.

It’s always good to have a legal record of the loan, especially when you are lending large sums of money.

Types of promissory notes

There are two main types of prom notes; secured and unsecured.

• Secured promissory notes

These notes are used when borrowers place security for the loan amount, typically an asset of value such as a vehicle or home. So if the borrower defaults on the promissory note, you have the right to claim full ownership of the asset the borrower placed as security for the loan.

Co-signed promissory notes fall under secured promissory notes as well. That said, be very careful when co-signing a loan because you are then legally responsible to pay off the loan together with interest and late-payment fees if the borrower refuses or fails to pay.

• Unsecured promissory notes

These notes are used when there is no need for security or collateral and when there is mutual trust between the lender and borrower.

Creating a promissory note

Identify essential elements

Below are the elements that should be included in any promissory note, regardless of the state or country.

• Lender and borrower details

The name and mailing address of both the lender and borrower. Can use either a personal or business address.

• Loan amount

The sum of money being borrowed. You should record the principal amount clearly in words and numbers both.

• Interest rate

The interest charged on the loan amount as an annual percentage. It can be either simple interest or compound interest.

There may be laws regarding the maximum interest rate a lender can charge from borrowers so be careful not to run into any legal issues.

• Payment option

Should payments be made as monthly installments or as a lump amount at the end of the loan period?

• Payment schedule

The date the first payment is due along with due dates of subsequent payments. For example, if the first payment is to be made on the 5th of April, all subsequent payments should be made on the 5th of every other month.

• Security

Assets such as real estate and vehicles are often taken as collateral when loaning large sums of money. Security or Collateral assures the lender that their money will be repaid in full on time.

If the borrower defaults on the loan, you will have the right to claim full ownership of the asset the borrower placed as collateral.

But if you trust the borrower, I recommend going for an unsecured promissory note because asking for collateral from close friends and family may hurt their feelings and make them feel that you are not trusting them with your money.

• Co-signers

In case the borrower doesn’t have any valuable assets to place as collateral, he/she may be required to bring in a 3rd person to co-sign the promissory note.

This way, if the borrower is unable to pay off the loan, the co-signer is the one who will be held responsible.

• Late payment penalty

The lender may charge an extra fee for being late on payments. $25 is a reasonable fee but that depends on the size and nature of the loan. Late payment penalties are only seen in loans with monthly installments.

• Pre payment penalty

Fee charged when payments are made prior to the agreed dates.

• Governing law

The residential state of the individual or business lending the money should be specified due to the differences of usury rates among states.

• Default clause

State what will happen if the borrower defaults on the loan clearly.

Run a credit report

You should run a credit history check on potential borrowers before lending them any money. This is done to check whether they have any outstanding debt and whether the payments have been made on time.

To run a credit report on someone other than yourself, you need written legal permission. You could then use Experian, a credit agency that lets you run credit reports for free if you are a lender but costs $14.95 if you are a borrower.

Request collateral

If any red flags show up in a borrower’s credit report, ask the borrower to add collateral or a co-signer to the promissory note. The most common types of collateral are real estate and vehicles. Even a mobile phone can be accepted as collateral depending on the size of the loan.

If the borrower refuses or is unable to pay back the loan within the given time-frame, the lender can claim full ownership of the asset used as collateral for the loan or have the co-signer legally accountable for paying back the entire loan amount, together with the interest and other outstanding fees.

Writing

It’s time to write down the terms that were agreed upon by both parties on paper. Unlike most other legal forms, promissory notes are much easier to understand and can be created even by someone who has little to no legal knowledge.

You could download a promissory note template and alter it to your needs. If you are not confident about the validity of the content in the note, run it through a lawyer.

Signing

The lender, borrower and co-signer must all sign the promissory note before money is passed to the borrower. The full name of each signor and the date signed must be entered as well.

Although not required, it’s good to have a witness sign the note as well. If the loan amount is more than $10,000, a public notary is required.

Collecting payments from a promissory note

What will you do if a borrower refuses to pay off the loan? There are several steps that you can take.

You could send a written reminder requesting them to make the due payments within 30 or 60 days. This does the trick most of the time but if the borrower still doesn’t respond, hold a face-to-face meeting and try to come to an agreement.

See whether the borrower can at least make a partial payment or whether extending the deadline would help.

The next best option is to get help from a debt collection firm. They will work towards recovering your loan amount and usually takes a small percentage of it as service fees.

If you are in a rush and don’t really care about insignificant losses, you could even sell the note to one such firm and get a decent percentage of the loan upfront. 

If everything fails, your only option may be to sue the borrower by filing a dispute in the small claims court or take some other legal action.

Conclusion

A loan without a promissory note is like a murder without a witness. You must always have a clear written record of the loan to legally bind the borrower to repay the loan amount on time.

This way there can be no confusions or questions about the amount of money lent and the due date of payments.

Do your research on laws related to promissory notes in your local state and country to avoid any loopholes that may surface when legal actions are taken against the borrower.

Be sure to run a credit report on potential borrowers before signing the prom note. As a general rule of thumb, don’t lend money to people who are typically late on their payments or people with too much outstanding debt.