If you borrow or lend money, a promissory note sets out the terms and details of your loan. While this might seem like another boring document to quickly flip through, it’s a key part of loans with very important – and legally binding – details.
If you are preparing to sign on the dotted line of a promissory note, it is essential to understand how a promissory note works and what it should include.
What is a promissory note?
A promissory note is a written agreement to pay someone – essentially an IOU. But this is not something to be taken lightly. “This is a legally binding written document making a promise to repay money,” says Andrea Wheeler, business attorney and owner of Wheeler Legal PLLC of Florida.
Promissory notes are often used in the financial services industry. Zachary D. Schorr, an attorney based in Los Angeles, says, “They are typically used for formal loans such as mortgages or commercial loans where the borrower promises to repay a loan in writing. “If you take out a car loan or a student loan, for example, you would sign a promissory note agreeing to the terms, conditions and repayment schedule.
A promissory note can also be used in less formal situations, such as when you lend money to a friend, family member, or business partner, to make the loan official. You probably don’t have to worry about lending a few dollars, but making a large personal loan to another person or even a business probably warrants a formal promissory note.
What a promissory note includes
For a promissory note to be valid and legally binding, it must include specific information.
“A promissory note should include details, including the amount loaned, the repayment schedule and whether or not it is guaranteed,” says Wheeler. But that’s not all. In fact, a number of details are required for a legally binding promissory note. If you are signing a promissory note, make sure it includes the following details:
Dated. The promissory note should include the date it was created at the top of the page.
Amount. The amount borrowed should be written in numbers and expressed in words, like writing a check. This way there is no chance that the amount owed will be misread or changed. For example, if the promissory note is $ 5,789, it should also say “five thousand seven hundred and eighty-nine dollars”.
Loan conditions. The loan terms explain how the loan will be repaid, including how often payments will be made (monthly, quarterly or annually), when the first payment is due and when the final payment is due. There should be specific dates rather than ambiguous deadlines.
Interest rate. This detail explains if there is interest charged on the loan, and if so, what will the rate be and whether the interest rate is fixed or variable. Just like the loan amount, the interest rate should be represented as a numeric percentage and written in long form. Wheeler also notes that the interest rate must comply with the state usury law.
Collateral. Some types of loans are secured by collateral in case the borrower is unable to repay what he owes. These are known as secured loans. If the loan is secured by collateral, the promissory note should detail what the collateral is and its value. For example, the borrower may be placing an asset as collateral. The promissory note should include a description of the property, including whether it is commercial or residential, its value and address. However, “not all promissory notes are secured by collateral,” Schorr says. “A promissory note is enforceable by way of an ordinary breach of contract claim.” In other words, the loan does not need to be secured; an unsecured loan is always enforceable as long as the promissory note is fully filled.
Information about the lender and the borrower. This section covers the names and contact details of everyone involved in the loan. It describes who the lender is and who the borrower is, as well as the mailing address or digital destination where payments are to be sent.
Signatures. Finally, to be enforceable, both parties must sign and date the promissory note, Wheeler says. This is how the borrower and the lender recognize that they understand the terms and their responsibilities. “It’s also good practice to have a promissory note notarized so that the lender can be sure that the right person is providing the promise to repay the loan,” says Schorr.
What happens when the loan is paid off?
When you reach the end of the loan, it’s a good idea to release everyone from their responsibilities. This can be achieved with a release of a promissory note or other document indicating that the loan is complete and paid in full.
While there is no way to fully protect yourself against possible claims, lawsuits, or other issues related to a loan you were involved in, the release document can strengthen your defense if something like this happens.
A promissory note release is appropriate when all parties have performed all of the tasks outlined in the original contract. Each party should consider whether they are satisfied with the way the loan conditions have been met. Additionally, if collateral has been used to back the loan, the discharge should state that there is no further lien or other holdback on it.
The release should include a few key details: a reference to the original promissory note and its date, as well as the original loan amount. The discharge must describe that the conditions of this document have been met and that the borrower is released from his obligations. And it should include the names and contact details of all parties involved, just like the original note.
The promissory note release must also be signed and dated by the lender and the borrower. As an additional measure, it may include a copy of the original promissory note with an annotation indicating “paid in full” or “canceled”.
Again, having this document notarized is an additional step you can take to ensure that it is valid and cannot be challenged later.