Loans 101: What is a promissory note?
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The term “promissory note” is often used casually, referring to an agreement between friends or acquaintances. But in the finance world, promissory notes are legally binding agreements. Is a promissory note the same as an IOU or a loan? If you've ever received or written an IOU, taken out a loan, or plan on doing so in the future, you need to understand what a promissory note is and what it entails.
A closer look at promissory notes
In its simplest form, a promissory note is a written commitment to pay something. It's not just any note, though - it's a legally binding contract where you agree to repay a certain amount of money to someone by a specific date. It's a formal pledge.
Promissory notes are legal IOUs that formally state you’ll repay a loan. They’re common tools in many financial transactions, such as mortgages, student loans, and car loans. If you've ever taken out a loan, you likely signed a promissory note, even if your bank called it something else.
In real estate, banks, lenders, and other financial institutions typically issue a promissory note to the borrower. The borrower must sign the promissory note, officially agreeing to repay their mortgage or loan by a certain date, often when the mortgage or loan matures.
There are a few different types depending on the transaction:
Secured promissory notes
Unsecured promissory notes
Master promissory notes
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Frequently asked questions
Believe it or not, promissory notes contain a lot of information despite their name. Here's what people are asking about promissory notes.
Q: What is a promissory note?
A: A promissory note is a legally binding document that outlines a loan between two parties. It specifies the amount borrowed, the repayment schedule, and the consequences of non-payment.
Q: Why is a promissory note important?
A: Promissory notes make the terms of a loan clear and legally enforceable, protecting both the lender and the borrower by defining expectations and consequences.
Q: Can a promissory note be used in any loan situation?
A: Yes, it can be used in a variety of loan situations, including personal loans between friends or family, as well as more formal loans like mortgages and student loans.
Q: How is a promissory note different from a contract?
A: While both are legally binding, a contract typically involves an exchange of goods or services, while a promissory note is specifically about a loan of money.
Q: What details should a promissory note include?
A: U.S. states have their own rules about what a promissory note must include. But standard elements include the borrower’s and lender’s contact information, loan amount, interest rate (if any), the repayment schedule, associated fees, collateral, loan conditions, loan maturity date, and the borrower’s signature.
Q: Can a promissory note be altered?
A: All parties should agree upon and document any changes in writing.
Q: Does a promissory note need to be notarized?
A: Notarization is not typically required, but it can add a layer of legal protection.
Q: What happens if a promissory note is not paid?
A: The lender may take legal action to recover the debt and/or any other actions as outlined within the promissory note.
Q: Can a promissory note be sold?
A: Promissory notes can be sold or transferred to another party, giving the new owner the right to collect the debt. But watch out for promissory note fraud. You must be properly licensed to sell a promissory note. Legitimate, licensed financial institutions may sell or trade promissory notes, but it’s unusual in the private sector. If anyone ever contacts you about investing in a promissory note, it’s likely a scam. You can verify most legitimate promissory notes through the SEC.
Q: Can a promissory note be canceled?
A: It can be canceled if both parties agree or if the debt is fully repaid.
Q: Can a promissory note be used in real estate transactions?
A: Promissory notes are commonly used in real estate transactions, particularly in the case of mortgages.
Q: Is a promissory note legally binding?
A: Yes, a promissory note is a legally binding document. If the terms of the note are not met, legal action can be taken.
Q: Can a promissory note be verbal?
A: While a verbal agreement can be considered a promissory note, it's harder to enforce legally. It's always best to put loan agreements in writing.
Q: Is a promissory note the same as an IOU?
A: Most IOUs simply acknowledge that a debt exists. A promissory note goes further by specifying the repayment terms and consequences of non-payment.
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