In layman's terms, a promissory note is a simple IOU. It shows a transaction whereby one party advances money for any purpose, and the receiving party promises to repay the loan. When the purpose of the loan is to purchase or renovate real estate, a mortgage supplements the promissory note to secure the debt.
Oversimplifying, a promissory note is a written promise to repay a debt. It identifies the contractual obligations of the borrower (promisor) towards the lender (promisee) in terms of the loan, such as the amount and timing of repayment, and the lender's recourse if the loan is not paid on the due date. A promissory note is not tied to real estate. It does not of itself give the lender any interest in the borrower's property.
Limitations of a Promissory Note
Because a promissory note is an unsecured contractual obligation to repay a loan, if the borrower defaults, the lender's only recourse is to sue the borrower for breach of promise. If the borrower declares bankruptcy, the debt evidenced by the note is secondary to the interests of secured creditors, so that the lender receives a distribution of the bankrupt debtor's assets only after secured creditors are paid.
As borrowers typically require considerable loans to purchase or rehabilitate real estate, a lender under a mere promissory note is at huge risk should the promisor default.
Security Through Collateral
Lenders look to minimize risk. When they advance significant sums of money such as in a real estate transaction, they invariably seek additional security to protect themselves should the borrower not make good on his promise to repay the loan. This security takes the form of a second legal document known as a mortgage or deed of trust.
The mortgage secures the property as collateral for the loan documented by the promissory note. The mortgage (or deed of trust) and the promissory note sit together and side by side. If the borrower defaults, theoretically the lender can sue the borrower under the promissory note, and sell the property under the mortgage to satisfy the loan amount. However, some states require the lender to choose his remedy.
Mortgages and Deeds of Trust
The mortgage or deed of trust creates a security interest in a piece of property. This document, and not the promissory note, gives the lender the right to foreclose on the borrower's home. While many people think of a mortgage as a debt over their house, it neither evidences a loan transaction nor creates an obligation to repay a debt.
In other words, a promissory note can exist without a mortgage, but a mortgage cannot exist without a promissory note. Sometimes the contractual promise to repay the debt and the real estate security are incorporated into a single document.
The Lender Holds the Promissory Note
Mortgages and deeds of trust are recorded in the register of deeds. This gives any purchaser or financier notice that the property is encumbered by a security lien. Promissory notes, creating no interest in land, are not recorded unless they incorporate the mortgage. The lender typically retains the promissory note. When the borrower pays off the loan, the lender marks the promissory note as satisfied and records a release of mortgage in the county land records.
Jayne Thompson earned an LLB in Law and Business Administration from the University of Birmingham and an LLM in International Law from the University of East London. She practiced in various “big law” firms before launching a career as a commercial writer. Her work has appeared on numerous financial blogs including Wealth Soup and Synchrony. Find her at www.whiterosecopywriting.com.