What Are Promissory Notes & How Do They Work?

When you borrow money, you make an agreement to pay the money back to the lender. When the agreement is in writing, it is called a promissory note. The promissory note details the agreement between the lender and the borrower, such as how much interest the borrower will pay and what happens if the borrower does not pay as agreed.

Documenting a Loan

With informal loan agreements between family or friends, it is a good idea to document the terms of the loan. A promissory note, in this case, can be an informal hand written document. It clearly defines the expectations and responsibilities of all of the involved parties, and can save confusion and bad feelings later on, particularly if one person thinks that the loan is a gift. Documenting the fact that a loan was made is also good for income tax purposes, as the Internal Revenue Service may believe that the money from the loan deposited into your checking account is income and try to collect taxes on it.

What They Include

Most promissory notes can be written by one of the parties involved, particularly if the terms are simple. You may also find online templates for writing promissory notes. The note includes the name of the person borrowing the money, or the maker, as well as the person lending the funds, or the holder or payee. The amount borrowed should be clearly written in both numeric and word form, like writing a check. The date of repayment and amount of periodic payments are defined, as well as any interest rate that will be paid on the loan.

Type of Repayment

An amortized payment is when you make the same payment during a certain period of time, weekly, for instance, and the payment is divided between principal and interest. A promissory note can also specify that you will pay the interest on the loan each period, with a final payment, or balloon payment, to be made at the end of the loan on a specified date. Another option is to pay a specified amount on a certain date that includes all principal and interest on the loan.

Security and Default

The promissory note also specifies any security interests, or collateral that the borrower gives to the lender to guarantee that he will pay back the loan. This borrower may give the lender a formal lien, or just promise to turn over property if he defaults on the note. The promissory note may also define what other steps the borrower must take in case of default, such as to pay extra fees or interest. The conditions in a promissory note are a legal agreement and may be enforced by a court.