What is a Promissory Note and How Does it Work?

Key takeaways:

• A promissory note is a legal document that outlines the terms of a loan, including repayment agreements, fees, and more, and obligates both the borrower and lender to abide by those terms.
• The note can include specific details such as the borrower and lender’s identities, the loan amount, interest rate, repayment terms, maturity date, and collateral (if any).
• There are two main categories of promissory notes: secured (with collateral) and unsecured (without collateral). Promissory notes are different from IOUs and are legally enforceable documents.

A promissory note is a legal document that includes extensive and specific details about a loan’s terms. Both the lender and the borrower sign a promissory note before a loan is funded, and doing so obligates both parties to abide by the terms—including repayment agreements, fees, and more.

Promissory notes establish the relationship between the borrower and lender (also known as the payor and payee), and clearly defines how much money is being borrowed and details of the expected repayment. 

What items are included in a promissory note?

This isn’t an exhaustive list, as promissory notes can be rather lengthy, but some of the common items you’re likely to find on a promissory note form include:

• Clear definition of the borrower and lender. A promissory note names the lender and borrower(s), which can be individuals, corporations, or other entities. A promissory note may be negotiable, meaning that the debt obligation can be sold or transferred to another lender. For example, if you’ve ever bought a car or house, and the company you send your payment to changes, that’s likely what happened.
• Total amount to be borrowed. This can include the loan principal plus any other fees that are rolled into the loan.
• Interest rate. Details of the interest rate and how often it is computed.  
• Repayment terms. A promissory note makes clear how much the borrower needs to repay at a time, at what interval the payments are to occur (typically monthly), and the total number of payments. Promissory note repayment terms also may contain a specific method of loan payment, such as automatic bank drafts, as well as what constitutes a default by the borrower.
• Loan maturity date. The promissory note makes clear when the borrower will have fulfilled their repayment obligations.
• Collateral. This doesn’t apply to all loans, but if there is collateral to be pledged as part of the loan, it will be stated in the promissory note. For example, if you get an auto loan, the specific details of the vehicle you’re buying will be included.
•  Important dates. A promissory note will contain the date of loan issuance, as well as several other important dates.

Types of promissory notes

There are several different subtypes of promissory notes, but 2 main categories are secured and unsecured.

Secured promissory note: If there is collateral being pledged as a condition of the loan, a secured promissory note is used. The biggest distinction is that a secured promissory note clearly states the collateral being pledged, as well as what happens with the collateral if the borrower defaults on the loan. A real estate promissory note is an example of this, as it makes clear that the home can be foreclosed upon if the loan isn’t repaid.

Unsecured promissory note: Unsecured promissory notes are a promise to repay a loan, but without any specific collateral being pledged. Unsecured promissory notes are legally enforceable, and while the lender cannot seize assets immediately upon default, there are usually details about what will happen if the loan isn’t repaid.

Promissory note vs. IOU

An IOU—an acronym for “I owe you”—is a document that acknowledges a debt exists as well as its amount, but it doesn’t contain nearly as much detail as a promissory note, especially when it comes to repayment terms and legal requirements. In a nutshell, a promissory note is a far more enforceable legal document than a simple IOU. 

Do all loans have promissory notes?

Technically, any individual, business, or agency lending money can issue a promissory note. If you loan a friend money, you can draft a legally binding promissory note outlining the terms of the agreement. There are plenty of promissory note templates and promissory note examples available online that you can use for this purpose. 

Some types of loans don’t have promissory notes, especially those that don’t have a set amount of money to be borrowed or a set monthly payment amount. Credit cards are the main example, as you’ll typically have a document known as a cardholder agreement that lists details of the relationship. This is a different type of document than a promissory note, but it is important to realize it is still a legally enforceable document.

Other types of loans have promissory notes in addition to other legal documents. A mortgage is a good example, as it also has a legally binding mortgage contract that gives the lender a security interest in your home.

A loan agreement is similar to a promissory note, and is often used by financial institutions, especially in cases where large amounts of money are involved. Loan agreements are lengthier documents that contain more through definitions and provisions than a promissory note.

The bottom line on promissory notes

A promissory note is a legal promise from a borrower to a lender to repay money in a specific timeframe and at specific intervals. Even if you’re lending money to a friend, a promissory note is more formal than a simple IOU and can help set clearly defined repayment terms. Plus, promissory note enforceability can give you legal recourse if the money isn’t repaid as agreed. And if you’re a borrower, a promissory note gives you the clear details of when you’re expected to repay money, and how you’re expected to make your payments.