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WHAT IS A PROMISSORY NOTE?

A promissory note is a written promise to pay a specific sum of money to a specific person by a specific date or on demand. It’s used in any type of lending situation, and is a legally-binding document which serves to protect the lender.

A promissory note is also used when a person sells an item to a third-party, such as a vehicle, appliance or jewelry. It’s a written promise that the buyer will pay the seller by a specific date or on demand. In this case, if the buyer does not keep his/her promise to pay; the seller may take back the item.

Financial institutions issue promissory notes for certain business transactions, but they are generally used when a buyer gets finance from a company or individual other than a bank.

Is a promissory note a legal document?

There’s a misconception that a promissory note is not much different to an old-fashioned IOU, when in fact it’s a legally-binding contract that has as much common law clout as a formal loan agreement. It includes the promise to pay and terms of payment, and gives the lender recourse if the borrower does not live up to his/her promise.

Promissory notes have been used for a very long time and at one point of time, they circulated as a form of alternate currency. It was called a demand note, where the borrower could decide when to demand payment.

Difference between a promissory note and a bank loan

A promissory note is different to a traditional bank loan because it allows anyone to become a lender. They have become increasingly popular for non-traditional lending, particular in a market where people don’t meet the lending criteria of traditional financial institutions.

A good example is purchasing property with a promissory note. This would be used where a potential buyer has the means to pay for the property but for various reasons, cannot apply for a mortgage from a bank. This may be because the buyer is an entrepreneur and can’t prove a steady and stable stream of income stream, or someone that’s been blacklisted.

In this case, the seller is the source of the loan and the sold property is the source of collateral. The buyer gives a down payment to the seller and the promissory note is used as security. The property deed acts as collateral and if the buyer defaults, the deed and the down payment are kept by the seller. It’s a bit like putting down a deposit on an item you’re interested in buying.

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What information is included in a promissory note?

A basic promissory note covers the following:

Details of the borrower and lender

Clearly identify the borrower and lender with names, addresses and identity numbers. If either the borrow or lender is a company, these details are required for the person representing the firm.

Loan amount and payment plan

A full description of the date the loan was made, the amount of the loan and how and when it will be paid. This includes whether interest will be charged and at percentage, as well as the date that a payment will be made either in part or in full. It also includes the maturity date of the loan.

Security agreement

State whether the promissory note is unsecured or secured. A unsecured promissory note means the lender will have to sue the borrower or many any other attempt to collect the money if the loan is not paid. A secured promissory note means that collateral is tied to it. A lender is entitled to seize whatever the borrower used the money to purchase, or foreclose on a business.

Terms of the promissory note

This covers other information that the borrower or lender needs to document so avoid a dispute or future claims. This includes a description of any late fees penalty and how the money will be collected or where payments will be made.

Type of promissory notes

Just about anyone can write a promissory note. Even if it’s written on a serviette and is signed by both parties, it’s just as valid as if it had been drawn up by a lawyer. In general, you’ll find the following types of promissory notes:

Personal promissory note

A record of a loan between two people, where the borrower promises to pay it back in full by a specific date. It’s a good idea to write a promissory note when family or friends lend money to each other because it protects the lender and avoids things getting ugly if the borrower doesn’t pay back the money.

Commercial promissory note

This is required by a commercial lender, and is typically more formal and strict than a personal promissory note. The commercial lender is entitled to demand payment in full if the borrower defaults on a loan.

Mortgage promissory note

A mortgage or real estate promissory note stands in a buyer in good stead until he/she can secure a home loan or make an initial upfront payment to secure the property.

Investment promissory note

This type of promissory note is used in a business transaction when a firm is attempting to raise capital for a business venture or such. It usually contains a clause that stipulates what return of investment is expected over a specific period of time.

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