Table of Contents
A promissory note is a written agreement between a borrower and a lender to formalize the lending of money.
Through this legal agreement, both the borrower and the lender consent to clearly defined repayment terms. Promissory notes can be used for a variety of purposes, including personal and commercial transactions.
In this guide you can learn about a promissory note’s definition, common types of promissory notes, how to create one, and when they may be a good option for borrowing or lending money.
Key Points
• A promissory note means an agreement that details a loan’s repayment terms.
• Different types of promissory notes cater to different loan scenarios.
• Borrowers may repay the loan in a lump sum or in installments, or the money may be due on demand.
• Interest rates and collateral may affect a promissory note’s level of risk.
• Promissory notes are legally binding, requiring signatures and compliance with state laws.
What Is a Promissory Note?
Put simply, the definition of a promissory note is a written promise to pay someone a certain amount by a specified time. The type of promissory note and agreement between the issuer and payee dictate the payment schedule and amount. If the borrower is a business, the issuer may wish to see its pro forma income statement when setting up a repayment schedule.
Similar to loans, promissory notes may be secured or unsecured. Unsecured notes are generally issued based on the borrower’s ability to repay, whereas secured notes use collateral such as real estate or a vehicle.
A promissory note may be issued by a financial institution, but this financing is commonly used by individuals and businesses, too. Essentially, promissory notes allow anyone to act as a lender, which can be useful for creating legal documentation of a lending agreement between family members and/or friends.
Core Components
Promissory notes generally include the principal amount, interest rate, date and place of issuance, and signatures from the borrower and sometimes the lender. There may also be provisions for late fees and recourse if a borrower defaults.
Interest Rate and Payment Terms
An important feature of a promissory note is the explanation of the interest rate and how it is arrived at. Bear in mind that your interest rate may be fixed or variable. If it’s fixed, calculating your payments may be relatively straightforward. If your rate is variable, it can change based on an index or benchmark and may be capped at a certain rate. That information should be clearly spelled out in the promissory note.
The payment terms for the loan are also key and should be detailed in the promissory note, as they will determine when and how repayments must be made. The note should include the frequency of repayments and a payment schedule.
Maturity Date and Default Clauses
A promissory note should also include the maturity date, which is the date by which the loan must be fully repaid. The default clauses explain under what circumstances the borrower is considered in breach of contract and what the consequences will be. For instance, some promissory notes have an acceleration clause, which typically states that if a payment is missed, the lender can demand the immediate payment of the outstanding balance.
How a Promissory Note Works in a Loan Agreement
In a loan agreement, a lender issues a promissory note that details the amount that will be loaned, the repayment terms, schedule, and dates, and any conditions about repayment and what can happen if the borrower defaults. When the borrower signs the note, it becomes a legally binding document between the parties.
The Role of the Borrower and Lender
As with any loan agreement, a promissory note involves a person or business borrowing money and a person or business loaning money. However, with promissory notes, the lender may not be a bank or typical lending institution. It’s also worth noting that although the lender may prepare the promissory note, it typically does not sign it, since it’s the borrower who is promising to pay. However, the lender’s legal rights in various situations – if the borrower misses a payment, for instance – should be detailed in the promissory note and the lender typically must abide by those stipulations.
When a Promissory Note Is Used
There are many situations in which it’s possible to use a promissory note, but here are the ones in which it’s the most common:
• Business loans and seller financing
• Real estate loans
• Personal loans (especially between friends and/or family)
• Student loans
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Types of Promissory Notes
There are several types of promissory notes. Usually, the nature of the loan determines the appropriate type. Here’s a closer look at some of the most common varieties.
Line of Credit Promissory Note
Borrowers can withdraw any portion of funds from a line of credit, up to the established maximum loan amount. Once the money is taken out, the borrower is liable for repaying the lender with interest.
A promissory note can be used to guarantee that the borrower repays money withdrawn from the line of credit. The promissory note can specify the interest rate, repayment schedule, and whether the line of credit is secured or unsecured.
Investment Promissory Note
Businesses looking to access capital can sell promissory notes to investors instead of taking out a conventional business loan or a line of credit. As with a conventional loan, however, the company will typically be expected to show the lender its balance sheet indicating that it is solvent.
Through an investment promissory note, businesses receive capital from investors in exchange for fixed repayments. In the event a business is unable to repay, the investors may acquire the company.
Generally, investment promissory notes are sold at a discount to account for the impact of inflation on future payments. Promissory notes may be sold publicly in some cases but are most often purchased by corporate entities and experienced investors with high net worth who can handle the greater level of risk.
Real Estate Promissory Note
Promissory notes can be used in mortgages and other real estate purchases. In practice, borrowers use a home or other property as collateral for a real estate promissory note.
While promissory notes can accompany a mortgage, they are in fact different. The note provides legal documentation of the borrower’s promise to repay the loan, whereas the mortgage outlines the lender’s recourse for foreclosure in case the borrower cannot pay. Qualifying for a mortgage may also require a loan contract and more detailed financial information.
Real estate promissory notes can also be used outside a mortgage. For example, two individuals could create such an agreement. Although the lender may not have the power of foreclosure, they can secure the agreement with the authority to place a lien on the property if the borrower defaults. A property lien creates a public record of a borrower’s unpaid debt.
Keep in mind that real estate promissory notes can be traded through brokerages without the borrower’s consent.
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Student Loan Promissory Note
College students will likely be required to sign a promissory note for both private and federal student loans.
For private lenders, each student loan may carry its own promissory note, as terms can vary. Anyone taking out federal student loans must sign a Master Promissory Note to promise repayment of loans, fees, and interest to the U.S. Department of Education. The MPN can cover multiple loans, but is now subject to new rules set by the One Big Beautiful Bill Act of 2025 so it’s wise to check your individual situation with a qualified advisor.
Recommended: Understanding Your Student Loan Promissory Note
Vehicle Promissory Note
A vehicle promissory note creates a binding document that promises a borrower will pay a lender for a car or other type of vehicle. This agreement can be between two individuals or between a borrower and a conventional lender, such as a bank.
In addition to repayment terms and conditions, it’s important to include the vehicle’s make, model, year, body, and VIN in a promissory note.
Personal Loan Promissory Note
It’s not uncommon to sign a promissory note when you’re acquiring a personal loan from a traditional lender.
A promissory note can also be used for a personal loan between friends or family. Formalizing the loan amount and repayment terms through a promissory note can help avoid disagreement and protect both parties down the line. Compared with typical personal loan requirements, a promissory note can be a more flexible financing option.
Having financial information like credit score and proof of income at the ready can streamline getting approved for a personal loan.
Secured vs. Unsecured Promissory Notes
A promissory note may be secured by collateral or unsecured. If the note is secured, the borrower specifies assets that the lender can legally claim if the loan is not paid back. With an unsecured note, the lender might need to go to court to recoup losses if the borrower defaults. Unsecured loans may represent a higher risk level for lenders than unsecured ones.
Promissory Note Repayment Options
Besides type, promissory notes may differ by repayment method. Borrowers can usually expect to repay money and interest through one of the following options:
• Lump sum: This requires the entire amount to be repaid in a one-time payment on a specific date. Lump-sum payments are more common with small loans.
• Due on demand: The borrower must repay the loan upon the lender’s request. Due on demand payment is used frequently for promissory notes between friends and family members. Any promissory note without written payment terms is considered due on demand.
• Installment: Installment payments follow a specified schedule (monthly, for instance) to pay back the loan over a longer period of time. Usually payments are structured in equal amounts and include interest.
• With (or without) interest: A promissory note can define the interest rate and any related contingencies.
In some cases, a promissory note may employ a combination of repayment options. For example, a vehicle promissory note may include an upfront lump sum followed by installment payments.
Structured Repayment Strategies
Here are some effects of the various repayment plans to consider.
• Amortized payments: The borrower makes equal payments each month, paying down principal and interest together.
Pro: The consistency makes it easy to plan and budget.
Con: The monthly installments may be costly.
• Equal monthly payments and a final balloon payment: Installments are likely smaller than with full amortization, because the borrower pays less toward principal; the balloon payment resolves that at the end.
Pro: Lower monthly payments preserve more cash on hand for other needs.
Con: If the borrower plans to refinance the loan before the balloon’s due date, they run the risk that interest rates may go up.
• Interest-only payments and a final balloon payment: With monthly payments applied only to interest, the borrower owes the entire principal until the final balloon payment.
Pro: This method allows for the lowest monthly payments.
Con: The borrower pays more interest because they have possession of the full principal throughout the term of the loan.
• Single payment of principal and interest: This is the lump sum method, where everything is paid back on a specified date. For the most part, only friends and/or family members will accept this arrangement.
Pro: Borrowers need not pay anything toward the loan each month (though escrowing money would be wise).
Con: If the business cycle is in a contraction phase when the note comes due, repayment of a large sum all at once could be very tough.
Legal Implications of Repayment
Signing a promissory note makes the borrower legally liable for the loan according to the terms of the note. In many states, defaulting on a promissory note that’s part of a mortgage contract, for example, could allow the lender to foreclose on the house and then sue the borrower personally for any deficiency.
Balloon Payments and Installment Payments
The terms of some promissory notes may include a balloon payment. These are payments that are larger than usual and may often be the final payment owed by the borrower. Having a balloon payment can mean that your monthly payments are lower, but will require you to ultimately make a large payment.
If your promissory note specifies installment payments, a schedule of payments should be included as part of the note. If you have a fixed rate of interest, your payments will all be exactly the same each time, making it easier to budget in advance. In the more unusual case that you have a variable rate, your payments may reflect changes in your interest rate, but are unlikely to rise as high as a final balloon payment.
What Does a Promissory Note Look Like?
There are different laws in every state regarding promissory notes. One common feature of promissory notes is that they must be written down. A verbal agreement between two parties will not qualify as a promissory note or carry the same legal enforceability.
Standard Template
Promissory notes must include language outlining an agreement and unconditional promise for the borrower to repay the loan. Additionally, the repayment must be money, rather than labor, professional services, or other capital.
Other details and elements generally needed in a promissory note include the following:
• Amount or principal: How much was borrowed and is to be repaid
• Payor: The party promising to repay the debt
• Payee: The party lending the money
• Interest rate: States how much interest is charged and how it will be calculated
• Start date: The date the promissory note becomes effective and funding is released to the payor
• Maturity date: When the interest and principal must be repaid in full
Without these elements, lenders may have trouble enforcing the promissory note.
Key Clauses to Review Before Signing
It’s important to understand and be comfortable with all the terms of your promissory note before signing it. You should check that it correctly represents the identity of both parties, the amount of the loan, and whether collateral is involved and, if so, what it is. You’ll also want to check the maturity date, the interest rate and how it’s calculated, the payment schedule, and how the payments are structured. Finally, it’s important to fully understand the default clauses, since they outline the legal ramifications if you default on your payments, which can include the seizure of any collateral you have put up and/or legal action.
Risks and Protections
Like any loan contract, a promissory note involves financial risk for both borrower and lender.
Unsecured promissory notes will likely entail a higher interest rate than secured ones. A higher interest rate makes paying off a loan more expensive, increasing the possibility of default.
Promissory notes secured with collateral tend to have lower rates, but borrowers who can’t pay the debt risk having their collateral seized.
Depending on due diligence, providing capital based on a promissory note may expose the lender to some financial risk if the borrower is untrustworthy. As noted, having collateral helps mitigate that risk.
As for protection, a promissory note safeguards the lender by recording the terms of the loan in a valid and enforceable contract. It protects the borrower by providing documentation of the loan in case of an audit.
Both parties should make sure the note follows state or federal laws governing loans or investments to ensure additional safety.
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How to Protect Yourself When Signing a Promissory Note
Remember that even if you are signing a promissory note about a loan you’re getting from a friend or relative, a promissory note is by definition a legal document. It’s important to be sure you understand it and its provisions, as detailed above. It is generally also a good idea to have it reviewed by a trusted lawyer, who may be able to explain anything that’s unclear, spot and address potential concerns, and suggest alterations to protect your interests.
The Takeaway
Promissory notes create a binding promise to repay borrowed money. This financial agreement can be used when you’re borrowing money from individuals, financial institutions, or both. To be valid, the note must contain all the important details about the principal, the loan term and the interest rate, and must be signed by the borrower (or by both parties, if there are specific obligations for the lender included).
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
What makes a promissory note legally binding?
A promissory note is legally binding if it includes the date of the loan, the dollar amount being borrowed, the signature of the borrower, the rate of interest and how it’s determined, any collateral involved, the start date, and the repayment time frame and structure. The note must also comply with any applicable state laws.
How is a promissory note different from a loan agreement?
A loan agreement is more comprehensive than a promissory note, with specific terms and defined rules and restrictions. Promissory notes usually suffice for loans from one person to another. If a business is involved or the loan amount is large, a loan agreement may be more appropriate.
Can a promissory note be transferred?
Yes, it’s possible to transfer ownership of a promissory note. If the borrower defaults, for example, the lender may sell or transfer the note to a debt collector. Or if the lender needs to raise cash, they can negotiate with a buyer and sell the note.
What happens if someone defaults on a promissory note?
If a borrower defaults, the lender usually sends them a demand letter. If the borrower still does not pay, the lender can hire a collections lawyer to sue and get restitution through a court judgment. The lender may also have the right to seize any collateral and sell it at auction.
How long is a promissory note valid?
What a promissory note’s length of validity is depends on your state. The statute of limitations for promissory notes can range from three to 20 years.
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