Promissory Note: What Is It and How Does It Work?

Whether you’re taking out a personal loan or a mortgage, understanding how promissory notes work is crucial for both borrowers and lenders. This article dives into the various types of promissory notes and the role they play in helping to formalize a debt obligation.

In essence, a promissory note is a written document that contains a promise by one party (the maker or issuer) to pay another party (the payee) a definite sum of money, either on demand or at a predetermined time in the future. 

These notes typically contain the terms involved with the debt, including the principal amount of the loan, the interest rate, and the repayment schedule.

Promissory notes can be used in a number of different scenarios when one party is lending funds to another. For example, you may be asked to sign one when taking out a mortgage or a personal loan. A promissory note can also be used when lending funds to a family member.

There are several common types of promissory notes.

 
Here’s a look at a few common scenarios when a promissory note may be used:

• Student Loan Promissory Notes
  Students may be required to sign promissory notes when taking out a student loan. When taking out federal student loans, a student may be allowed to sign a one-time promissory note known as a master promissory note.¹
  
  
• Mortgage Promissory Notes
  You may be asked to sign a mortgage promissory note when taking out a mortgage. Typically this will include the loan’s interest rate, payment dates, repayment length of time, and more.²
  
  
• Personal Loan Promissory Notes
  When loaning money to friends or family, a promissory note may be used. This can help to prevent disagreements about the terms of the loan down the road.³

Promissory notes may also be secured or unsecured, depending on the situation.

• Secured Promissory Notes
  These are backed by collateral. If the borrower defaults, the lender may have the right to repossess the property. This type of note is common in mortgage lending.⁴
  
  
• Unsecured Promissory Notes
  Unlike secured notes, unsecured promissory notes do not have collateral backing them.⁵

A promissory note typically includes the following elements:⁶

• The name and address of the borrower and lender
• The maturity date
• The amount borrowed
• The payment schedule
• The interest rate
• Prepayments process
• Interest charged for overdue payments
• Default
• Waivers, amendments, and governing laws

A mortgage promissory note may include:⁷

• The amount you owe
• The interest rate
• How interest could change if you have an Adjustable Rate Mortgage (ARM)
• Payment dates
• Repayment amount of time
• Where to send payments
• Consequences of not making monthly payments

It’s important to review and understand each part of the note before signing. If you’re unsure about any terms or conditions, seeking legal advice can help clarify your obligations and protect your interests.

Promissory notes may be structured in different ways when it comes to repayments as well. 

Here’s a look at some of the different ways that a promissory note may be structured:

• Installments
  With installment payments, the borrower is required to make regular payments with interest over a set period. They are predictable and commonly used for auto loans or personal loans with a fixed repayment schedule.⁸
  
  
• Balloon Installments
  Balloon payments may be used in mortgage loans. With a balloon payment promissory note, the borrower typically pays a low interest rate for a period of time, buy only pays back a fraction of the principal balance. At the end of the loan term, the borrower may opt to reset the loan or pay off the remaining balance.⁹
  
  
• Due On a Specific Date (DOSD)
  DOSD promissory notes are straightforward and require the repayment of a loan by a certain date. These notes can be used when loaning small amounts of money to a friend or family member.¹⁰
  
  
• Due On Demand
  With this type of note, there is no concrete payment date specified, and borrowers can pay back the loan when they are financially able to do so. The lender may also be able to request repayment at any time. This flexibility also makes them an option to consider when lending funds to friends and family.¹¹