A promissory note is a written document that outlines a promise to pay a specific principal amount from the borrower to the lender. Sometimes called an IOU or loan agreement, it serves as a legal assurance that the borrower will repay the loan amounts under clearly defined terms. When properly executed, a promissory note becomes a legally binding contract, enforceable by law.
Key components
Promissory notes are typically straightforward and involve two parties: the borrower (also known as the “maker”) and the lender (referred to as the “payee”). These notes can either be secured promissory notes, where collateral is used to secure the loan, or unsecured promissory notes, which don’t require any assets to back the debt.
What’s typically included in a promissory note:
Additional clauses may address dispute resolution, governing laws, or amendments. Notarizing the note—especially for informal agreements—adds a layer of protection and legal enforceability.
Promissory notes fall between casual IOUs and more formal loan contracts. While an IOU simply acknowledges a debt, a promissory note goes further by outlining a promise to pay the debt either on demand or at a specified future date. It also defines how the repayment will occur—such as through a scheduled series of payments.
While banks and financial institutions often issue promissory notes for small personal loans, these notes are also used outside traditional banking. Private individuals and companies can lend money and use promissory notes to formalize the arrangement. Essentially, they allow anyone to act as a lender, provided all parties agree to the terms.
At its simplest, a promissory note might be used to lend money to a family member, while more complex versions are often subject to oversight from state or federal securities regulators.
A comprehensive promissory note should clearly state all terms of the loan. Elements to include:
These details create clarity and reduce disputes between parties.
There are several types of promissory notes, each designed to suit different borrowing and repayment scenarios. Key differences lie in whether the note is secured, repayment structures, and intended use.
This note includes only essential elements such as loan amounts, interest rate, and payment schedule. It's commonly used for smaller personal loans with a single borrower.
A secured promissory note involves the borrower offering collateral (like a vehicle or equipment) to secure the loan. If the borrower defaults, the lender can seize the collateral as compensation.
Unsecured promissory notes don't require collateral, but are still legally binding. These are typical in real estate transactions, where the mortgage itself acts as the security instrument. While the promissory note is a written commitment to repay, the mortgage allows foreclosure if payment isn’t made.
A master promissory note covers multiple loans under one agreement. It’s frequently used for student loans, where borrowers anticipate taking several loans over time. This allows recurring borrowing without drafting a new agreement for each transaction.
This functions like a line of credit. Rather than receiving the full amount upfront, the borrower can access smaller amounts over time, repaying each as agreed. The same loan contract governs the ongoing borrowing and repayment.
A demand promissory note doesn’t have a fixed payment schedule. Instead, the full amount becomes due whenever the lender requests it—usually with a notice period defined in the note.
This structure features smaller payments early in the term, followed by a large “balloon” payment at the end. It’s especially useful for small businesses, giving them time to build cash flow before settling the final lump sum.
A promissory note is essential any time money changes hands under a repayment expectation—whether between individuals, companies, or financial institutions. It protects the lender by establishing a clear record of the loan agreement, repayment terms, and legal remedies in case of default.
Promissory notes can be tailored to suit specific transactions. Using a sample can ensure you include interest, the correct legal language, and all necessary clauses.
For example:
Businesses frequently use promissory notes for various purposes, such as:
These uses show the flexibility of promissory notes as reliable tools in both personal and professional financial arrangements. In commercial settings, bills of exchange and promissory notes often serve complementary roles in managing financial transactions.
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