# Promissory Note: What It Is, Different Types, and Pros and Cons

## What Is a Promissory Note?

A promissory note serves as a formal commitment by one party to remit a specified amount of money to another, either when requested or at a predetermined future date. It is more structured than an IOU but less rigid than a formal loan agreement. This financial instrument encapsulates crucial details like the principal amount, interest rate, maturity date, and repayment plan, clearly delineating the financial obligations between the issuer and the payee. By offering flexibility, promissory notes provide diverse opportunities for lenders beyond traditional banking institutions.

### Key Takeaways

*   A promissory note is a formal financial promise by one party to pay another a specific amount of money, either on demand or on a predetermined date, and it often includes important details like interest rates and payment schedules.
*   Promissory notes can be secured with collateral or unsecured, with the former offering lenders a claim on specific assets if the borrower defaults.
*   Various types of promissory notes are used for different purposes, including student loans, mortgages, and corporate credit, each with unique structures and associated legal implications.
*   While promissory notes can offer alternative financing options outside of traditional banks, they carry certain risks, and potential investors should thoroughly investigate any offers, especially those promising high returns.
*   Historically, promissory notes have operated as an alternate form of currency in some regions, showcasing their longstanding role in global finance.

![Promissory Note Definition](https://www.investopedia.com/thmb/yN7HGmCNvm43PCItEYYu6489QrI=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/Term-Definitions_Template_promissorynote.asp-76c1a84d9d5344abb8f3c4110233207e.jpg)

*— Investopedia / Tara Anand*

## Understanding the Functionality of Promissory Notes

Promissory notes can lie between an IOU's informality and a loan contract's rigidity. An IOU merely acknowledges a debt and the amount one party owes another. A promissory note includes a promise to pay on demand or at a specified future date, in addition to steps required for repayment (like the repayment schedule)

Financial institutions can issue promissory notes for personal loans. They also enable companies and individuals to receive financing from non-bank sources, like other individuals or companies, under agreed terms. This means anyone can act as a lender through promissory notes.

In its simplest form, a promissory note might be a written promise to repay a family member. State or federal securities entities may regulate more complicated promissory notes.

> **Important**
>
> Typically, there are two parties to a promissory note: The promisor, also called the note's maker or issuer, promises to repay the amount borrowed. The promisee or payee is the person who gave the loan.

### Comparing Secured and Unsecured Promissory Notes

A promissory note can be secured or unsecured. A secured promissory note explains the collateral, often property, that backs the debt. If the borrower owns a property, it can serve as collateral. If the borrower defaults, the lender can take the property.

An unsecured promissory note doesn't involve collateral. In this case, if the borrower doesn't repay the loan, the lender can try to use standard debt-collection procedures.

In either case, the lender holds the promissory note until the debt is repaid. Typically, those drafting a promissory note will consult with an attorney to make sure the note follows any state or federal laws around loans or investments.  

> **Important**
>
> A promissory note is usually held by the party that's owed money; once the debt has been fully paid, the note must be canceled by the payee and returned to the issuer.

## Essential Components of a Promissory Note

A promissory note should detail the loan and repayment terms. It typically includes the borrower and lender’s names, along with:

*   Name and address of borrower and lender
*   Maturity date
*   Sum borrowed
*   Payment schedule
*   Interest rate and how interest is calculated
*   Prepayments process
*   Overdue payment interest charged
*   Default
*   Waivers, amendments, and governing law for the promissory note

## Various Types of Promissory Notes Explained

In the United States, promissory notes are often used when getting a student loan, mortgage, or a loan from a friend or family member. Promissory notes are also sometimes issued to corporate clients.

### Student Loan Promissory Notes

Many people sign their first promissory notes as part of getting a [student loan](https://www.investopedia.com/terms/s/student-debt.asp). Private lenders typically require students to sign promissory notes for each loan taken out.

Some schools allow federal student loan borrowers to sign a one-time master promissory note, allowing receipt of multiple loans for up to 10 years if the school certifies the student's continued eligibility.

Student loan promissory notes outline the student borrower's rights and responsibilities and the loan's conditions and terms. By signing a master promissory note for [federal student loans](https://www.investopedia.com/articles/personal-finance/042415/earn-credit-card-rewards-paying-student-loans.asp), the student promises to repay the loan amounts plus interest and fees to the U.S. Department of Education.

The master promissory note also includes the student's personal contact and employment information, as well as the names and contact info for the student's references.  

### Mortgage Promissory Notes

Homeowners usually consider their mortgage an obligation to repay the money they borrowed to buy their residence. But actually, the signed [mortgage promissory note](https://www.investopedia.com/mortgage-note-5221502) represents a promise to repay the mortgage or loan, along with the repayment terms.

Typically, the promissory note includes:

*   Amount you owe
*   Mortgage loan's interest rate
*   Ways your interest rate can change, if you have an Adjustable Rate Mortgage (ARM)
*   Payment dates
*   Repayment length of time
*   Where you send payments
*   Consequences of not making monthly mortgage payments

The promissory note describes the debt's amount, interest rate, and late fees. A lender holds the promissory note until the mortgage loan is paid off. Unlike the mortgage or [deed of trust](https://www.investopedia.com/terms/t/trustdeed.asp), the promissory note is not entered into county land records.  

### Corporate Credit Promissory Notes

Promissory notes are commonly used in business as a means of short-term financing. For example, when a company sells products but hasn't yet collected payments, cash may run low, leaving the company unable to pay creditors. The company may ask creditors to accept a promissory note to be exchanged for cash after the company collects its [accounts receivables](https://www.investopedia.com/terms/a/accountsreceivable.asp).

Or the company may ask the bank for cash in exchange for a promissory note. Companies may use promissory notes for credit when other options, like loans or bonds, are unavailable. These notes are riskier than corporate bonds, often offering higher interest rates due to their higher default risk.

These notes must be registered with the government in the state where sold and with the Securities and Exchange Commission (SEC).

If the note is not registered, the investor has to analyze whether the company is capable of servicing the debt. Companies in dire straits may hire high-[commission brokers](https://www.investopedia.com/terms/c/commission-broker.asp) to push unregistered promissory notes on the public. If the company defaults, the investors' legal avenues may be somewhat limited.

## How Promissory Notes are Repaid

There are several different structures for repayment of a promissory note, but most involve repaying the principal plus interest. The interest rate can be fixed or variable and calculated daily, monthly, annually, or in another way. In some states, interest rates may be capped by state law. A certified accountant and attorney can advise you on the tax or legal implications of the promissory note's repayment schedule.

Here are various repayment approaches for a promissory note:

*   **Installment note**: The most familiar repayment approach is through installments, with the borrower making regular payments; the repayment schedule and interest payments can vary.
*   **Simple note:** For smaller loans, borrowers might arrange a [lump-sum repayment](https://www.investopedia.com/terms/l/lump-sum-payment.asp) on a specified date, meaning that's when you'll repay the whole amount listed in the promissory note.
*   **Open-ended note**: This promissory note allows the borrower to draw on an operating or other loan over time and repay the draw plus interest by a specific date.
*   **Demand note**: Sometimes, a promissory note may specify "on demand" repayment, meaning that the note must be repaid at the lender's request at any time.

## Analyzing Investment Opportunities in Promissory Notes

Company or corporate promissory notes are rarely sold to the public. When they are, it is usually at the behest of a struggling company working through unscrupulous brokers who are willing to sell promissory notes that the company may not be able to honor.

Alternatively, the promissory note may be part of a scam sold by life insurance agents or online or out-of-state investment advisors. Some sellers may know nothing about the investments' true origins—the promissory notes may be for companies that don't exist. Promissory notes promising "low risk, high yield" investments may lead to a type of fraud, according to the SEC.

Before investing in promissory notes, ensure all of the following are true:

*   The person selling the promissory notes is licensed to sell securities 
*   The company offering promissory notes is legitimate and can repay debts
*   Promissory notes are properly registered by the SEC, state securities regulator, or legally exempt from registration
*   If guaranteed or insured by a foreign insurance company, contact your state department of insurance to make sure the company can do business in the U.S.

Investing in promissory notes involves risk. These promissory notes are only offered to corporate or sophisticated investors who can handle the risks and have the money needed to buy a note. To help minimize these risks, an investor must register the promissory note or have it notarized so that the obligation is publicly recorded and legal.  

## The Evolution of Promissory Notes Over Time

Promissory notes have had an interesting history. At times, they have circulated as a form of alternate currency, free of government control. In some places, the official currency is a form of promissory note called a [demand note](https://www.investopedia.com/terms/d/demandnote.asp) (one with no stated maturity date or fixed term, allowing the lender to decide when to demand payment).

Promissory notes and [bills of exchange](https://www.investopedia.com/terms/b/billofexchange.asp) are governed by the 1930 Geneva Convention of Uniform Law on Bills of Exchange and Promissory Notes. Its rules stipulate that the term "promissory note" should be inserted in the instrument's body and contain an unconditional promise to pay.

## What Does a Promissory Note Contain?

A form of debt instrument, a promissory note represents a written promise on the part of the issuer to pay back another party. A promissory note will include the agreed-upon terms between the two parties, such as the maturity date, principal, interest, and issuer’s signature. Essentially, a promissory note allows entities other than financial institutions to provide lending services to other entities.

## What Is an Example of a Promissory Note?

One example of a promissory note is a corporate credit promissory note. For this type of promissory note, a company will typically be seeking a short-term loan. In the case of a growing startup that is low on cash as it expands its operations, the terms of the agreement could state that the company pays back the loan once its accounts receivable are collected.  

There are several other types of promissory notes, including investment promissory notes, take-back mortgages, and student loan promissory notes. 

## What Are the Pros and Cons of a Promissory Note?

A promissory note can be advantageous when an entity is unable to secure a loan from a traditional lender, such as a bank. However, promissory notes can be risky, as the lender may not have the same means and scale of resources as traditional financial institutions. At the same time, legal issues could arise for both the issuer and payee in the event of default. Because of this, getting a promissory note notarized can be important.

## The Bottom Line

A promissory note is a written promise by one party to make a payment of money at a date in the future. Although potentially issued by financial institutions, other organizations, or individuals can use promissory notes to confirm the agreed terms of a loan. In short, a promissory note allows anyone to act as a lender. However, the average investor should be wary of and heavily research any sales pitches for promissory notes as an investment.  

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>     
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