The Correct Way to Use a Promissory Note

Promissory notes can be used in many different ways.

For businesses, Promissory Notes are often used for short term financing. They can provide small business an avenue to obtain financing when they are unable to qualify for traditional loans. However, before signing a promissory note, it is important to understand what they are, how they are used, what exactly they do, and more importantly what they do not do.

In fairly simple terms, a promissory note is a financial instrument that contains a written promise by one party (the maker) to pay another party (the holder) a definite sum of money. With regards to legal enforceability, promissory notes provide more protection than a simple IOU, but less protection than a formal contract.

Whereas a formal written contract would include all the terms of the legal agreement, a promissory note typically contains only the basic, material terms related to the indebtedness. A promissory note would include information such as the principal amount, interest rate, maturity date, date and place of issuance, and maker’s signature. You may have noticed there that I did not list the holder’s signature. That is because the holder is not required to sign the note and often doesn’t do so. The promissory note is commonly only signed by the maker since the holder is not making any commitment under the note. Even in the case of a loan, the transfer of funds is separate from the note itself.

It’s important to note that a promissory note is not a substitute for a formal contract. The promissory note only concerns the payment. Let’s say you are buying a business and the seller has you sign a promissory note and that’s it. No formal purchase agreement. Now, you could be in a lot of trouble because the promissory note does not contain the seller’s obligation to turn the business over to you. Basically, if the seller doesn’t give you the business, you have to take them to court with no written evidence of your agreement. Meanwhile, the seller has written proof that you owe him or her money. That is certainly not an ideal circumstance, so you’re probably better off using a formal purchase agreement. If on the other hand, your business is loaning money to someone, depending on the circumstances surrounding the loan, you may be okay with just a promissory note.

Homebuying is one place that many people have seen promissory notes without realizing it. People tend to think that their mortgage is their obligation to pay the loan. Although practically, there is no harm in thinking of it that way, the legal mechanics of the loan are a little different. Homebuyers actually sign a promissory note. The note contains the obligation to pay. The lender then takes a security interest in the house. That security interest comes in the form of the mortgage.

Although promissory notes are used in situations like mortgages where there is a security interest, that is not always the case. Often, a promissory note documents an unsecured loan. The term “unsecured” in this context means there is no collateral for the lender to seize if the borrower defaults. In these instances, the notes typically cover a much shorter term and include a higher than usual interest rate.

Another thing to be aware of is that in many cases, a promissory note can be sold. This means that the holder of the note can sell the note to a third party. In that instance, the maker would continue to make payments on the note, but would make those payments to the new party who purchased the note. The holder of the note bears a certain degree of risk that the maker will not pay. If that happens, the holder may still have legal recourse, but litigation takes time and costs money. Oftentimes, rather than continue to bear that risk, the holder prefers to receive payment right away. In these cases, the holder will sell the note, almost always for less than the outstanding balance on the note. This benefits the seller of the note because she gets her money up front and there is no more risk, but the total amount received is lower. The buyer of the note assumes risk that the maker will default but stands to profit on the deal if the maker pays the full debt.

Promissory notes can be extremely useful tools under the right circumstances, but it is important to be aware of their limitations. Consult your attorney if you’re unsure about using a promissory note. Promissory notes are less complex than formal contracts and can be a great solution where they are appropriate, but in the wrong circumstances, they can leave you under protected.

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