Dictionary
Debitoor's accounting dictionary
Promissory note

Promissory note – What is a promissory note?

A promissory note, also known as ‘notes payable’, is a monetary contract, in which one party promises in writing to pay the other a determinate sum of money.

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A promissory note will normally include all terms related to the indebtedness of the note’s issuer. These terms will include the principal amount that is owed, the interest rate, the maturity date, the date and place the note was issued, along with both parties’ signatures.

Financial institutions can issue notes payable. However, these debt instruments are more commonly used by companies and individuals to get financing from sources other than banks. The payee, i.e. the one who is willing to carry the note and provide the financing, can be either an individual or a company.

Is a promissory note legally binding?

A promissory note should contain all of the terms and conditions associated with the agreement between the issuer and the payee. It’s only valid if it involves an exchange of money. The note needs to detail the total amount of money or capital that’s been loaned, the interest rate that is to be charged, information about defaults and penalties, and the timeline for the repayment. It can be a good idea to use a promissory note template when drafting your notes payable.

Once all of these conditions have been included in the details of the promissory note and it has been signed by both parties, the notes payable then meets the elements of a legally binding contract. It can then be used as a legal tool to bind the borrower to an agreement for purchasing goods or borrowing money.

If a promissory note details all of the terms and conditions clearly and has been signed, it’s subject to the full effect of the law. A promissory note can be created very quickly and is a simple way to create a binding legal agreement without requiring expert legal guidance from a licensed attorney. It’s an inexpensive way for any individual or company to protect their interests

A promissory note is valid until the terms and conditions have been met, i.e. until the debt has been paid off. However, the note can be voided if it’s altered. Renegotiation between the lender and debtor is valid if both parties sign off on the changes.

Enforcing a promissory note

In terms of promissory notes’ legal enforceability, it’s possible to place them somewhere between the informality of an IOU (I owe you) and the rigidity of a loan contract. An IOU only acknowledges that a debt exists, whereas a promissory note includes a specific promise to pay the debt, and the steps of repayment.

A loan contract is then stricter and usually gives the lender the right to foreclosure in the event of defaults on loan repayments. This detail is usually missing from promissory notes.

It’s always important that if you lend money, you’re sure that you will be repaid. You therefore need to secure the agreement between yourself and the lender. There are two forms of notes payable:

  • Secured promissory notes
  • Unsecured promissory notes.

Secured promissory notes

A promissory note might not be enough to secure a loan. Therefore, the note could contain a personal guarantee which would make it a secured promissory note. With a secured promissory note, the borrower can offer collateral which will guarantee that they will repay the lender. If the borrower is then unable to repay the loan, the lender can repossess the assets that were included in the promissory note.

The assets that can be repossessed can be both tangible and intangible. Tangible personal property could include, for example, a car, machinery, or products. Intangible personal property, on the other hand, exists on paper but doesn’t occupy physical space in the real world. The types of assets that could be repossessed in this category are things like stocks or intellectual property, for example.

At times, a personal guarantee is not enough sufficient for a lender. A third-party guarantor may then need to sign the promissory note on the borrower’s behalf. The third-party guarantor then takes on the responsibility of the debt in the event that borrower defaults on repayments.

Unsecured promissory notes

Unsecured promissory notes are riskier for lenders than secured promissory notes. This is because there’s no property attached to the loan, so there’s nothing for the lender to repossess if the borrower defaults on the loan. Whilst this may be a disadvantage, the benefit of lending money without collateral bound to the promissory note is that the lender can charge a higher interest, due to the note’s riskier nature.