What Is a Promissory Note?

July 27, 2023
A promissory note is a signed agreement between two parties where the borrower promises to pay back the lender for the money they’ve borrowed. They are legally enforceable financial instruments under the 1930 Geneva Convention of Uniform Law on Bills of Exchange and Promissory Notes. Promissory notes can be perceived as a more official way to borrow money than simply writing an IOU. However, they are less restrictive and complex than applying for a new loan since promissory notes don't require underwriting.

Promissory Notes vs. Loans - What's the Difference?

Both promissory notes and loans are ways to document the exchange of money between two parties and the terms of repayment. However, there are some differences between these two instruments that can make one more advantageous than the other in certain situations.

What is a Loan?

Typically, when someone considers borrowing money from a financial institution or another person, they think of getting a loan. A loan is a formal contract that details the terms of the arrangement:

●       How much is being borrowed

●       When it will be paid back

●       The applicable interest rate

●       Etc.

Oftentimes the language used in a loan contract is very formal and complex.

To qualify for the loan, the applicant usually has to meet strict eligibility requirements set by the financial institution. These might be qualities such as having a certain level of income, minimum credit score, employment status, debt-to-income ratio, etc.

When the borrower submits their application, it will have to pass through underwriting before it can be given approval. If done manually, this can be a lengthy process that can take days or even weeks to process.

What is a Promissory Note?

Just like a loan, a promissory note also can also be used to borrow money. It too will often contain details about the terms of the loan. However, the language used in a promissory note will generally be less rigid.

Additionally, promissory notes do not have to pass through underwriting. Anyone who wishes to lend money to another party can write a promissory note. They alone can determine what qualifications the borrower must meet and if they are willing to accept the risk of lending them funds.

It should also be noted that because promissory notes are financial instruments, they can be resold to third-party buyers.

Which is Better?

When it comes to deciding between a promissory note and a loan, it’s a question of using the right tool for the job.

Generally speaking, loans are best used in instances where large sums of money are going to be borrowed (such as a mortgage or auto loan). Meanwhile, promissory notes are better suited for cases where smaller sums of money are being exchanged under less formal arrangements (such as lending money to a friend or family member).

Types of Promissory Notes

As a means of covering all the legal bases, most major lenders will require loan applicants to sign both the loan agreement and a promissory note. Effectively, this is a way of covering all legal bases by documenting the terms of the loan and having the applicant pledge that it will be paid back on time.

Specific examples include the following:

●       Mortgage promissory notes

●       Student loan promissory notes

●       Corporate credit promissory notes

Secured vs. Unsecured Promissory Notes

Similar to a loan, promissory notes can be secured or unsecured.

●       With a secured promissory note, collateral (i.e., something of value such as the title to a vehicle or equities) will be used to secure the arrangement. If the borrower does not fulfill their obligation to pay back the funds, then the lender gets to keep the collateral.

●       With an unsecured promissory note, no collateral will be exchanged. The lender assumes the risk that the borrower will fulfill the terms of the promissory note. Typically, this risk will be offset by requiring the borrower to pay a higher APR than they would if collateral had been used.

How Do You Write a Promissory Note?

There are many online legal services and templates that can be used to draw up a promissory note. The text should typically include the following:

●       Borrower's name and contact info

●       Lender's name and contact info

●       The amount being borrowed

●       Maturity date

●       Payment schedule

●       Interest rate

●       Additional charges if a payment is late

●       Fine print

Additionally, the promissory note is not enforceable until it’s signed by both parties. Though most states do not require the use of a notary, having one authenticate the signatures can help give the contract better legal grounds in the event that an issue arises and the matter must go to court.

The Bottom Line

Promissory notes are written tools used to formally exchange money between two parties. They are similar to loan contracts but are often less restrictive and better suited to situations involving smaller sums of money.

Anytime someone lends money to someone else, a promissory note should be drawn up and signed by both parties. This makes the contract legally enforceable in court should the borrower ever default.