Promissory Note – Definition

Cite this article as:"Promissory Note – Definition," in The Business Professor, updated June 2, 2019, last accessed October 20, 2020, https://thebusinessprofessor.com/lesson/promissory-note-definition/.

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Promissory Note Definition

It is a financial instrument specifying a written promise from one party (the issuer or maker of the note) to pay a certain sum of money to another party, either at a specified future date or on demand. This note contains all the terms related to indebtedness, like the principal amount, maturity date, interest rate, date and place of issuance, as well as issuer’s signature.

Though the financial institutions can also issue the promissory notes, which are the debt instruments that enable  individuals and companies to raise funds from a source other than a bank. The source may be an individual or a company ready to hold a note (and grant financing) under the mutually agreed terms.

A Little More on What is a Promissory Note

Promissory notes and bills of exchange, are regulated by the 1930s international convention, stating that term “promissory note” must be included in the body of the instrument and specify an unconditional promise to pay.

In view of the legal enforceability, promissory notes somewhat contains the informality of an IOU but the strictness of a loan contract. A promissory note does not only include a promise to pay, but also the steps to do so (including repayment schedule), while an an IOU just acknowledges the existence of debt, and the sum one party owes another. On the contrary, a loan contract, generally specifies the  lender’s right to recourse – like foreclosure – in case of default of the borrower; such provisions are usually not mentioned in the promissory note. While it may make note of the implications of non-payment or irregular payments (like late fees), it does not generally define the ways of recourse if payment is not made by the issuer.

Promissory notes, when unconditional and saleable, tend to be negotiable instruments widely used in business transactions in various countries.

A promissory note is typically held by the party owed money. After the full discharge of debt, it the payee must cancel it, and return it to the issuer.

Students and Promissory Notes

Many students use promissory notes to fund their education. Private lenders offer different loans to the students and in turn, get signed promissory note from them. Each loan required separate promissory note. However, certain schools permit federal student loan borrowers to sign a only one master promissory note. Then the student can get various federal student loans as long as the the student maintains his/her eligibility.

Student loan promissory notes define rights and responsibilities of student borrowers, along with the terms and conditions of the loan. A master promissory note specifies that a student promises to repay the loan amounts along with  interest and fees to the U.S. Department of Education. It also includes student’s personal contact data, employment information as well as contact details of personal references.

History of Promissory Notes

Traditionally, they have been issued as a kind of alternate currency, which is not controlled by the government control. In some countries, the official currency is even in the form of promissory note, which is called a demand note (having neither maturity date nor fixed term, letting the lender to raise demand for payment whenever he wants). In the United States, though, the promissory notes are generally issued just to the corporate clients and sophisticated investors. Recently, promissory notes are also being heavily seen in securing mortgages and selling homes.

Mortgages and Promissory Notes

Homeowners generally consider their mortgage an obligation to repay the sum they borrowed to purchase their home. But actually, it’s the promissory note they sign, representing the promise to pay back the loan, with all defined repayment terms. The promissory note mentions the debt size, its interest rate as well as late fees. In such instance, the lender keeps the promissory note until mortgage payment is done. The promissory note is also not entered into in county land records.

The promissory note also helps when someone doesn’t  qualify for a mortgage to buy a home. The is called a take-back mortgage, and is quite simple. The seller keeps holding the mortgage (taking it back) on the home, while the buyer signs a promissory note. Through promissory note payments, the seller gets a positive monthly cash flow.

Generally, the buyer makes a big down payment to build seller’s confidence for buyer’s future payments. Although it is based on the state and situation, the deed of the house is sometimes used as a collateral, which is given back to the seller in case buyer fails to make payments. Some cases involve third party as creditor but it is a complex process, prone to legal issues in the case of inability to repay.

From the homeowner’s perspective who wishes to sell, the detailing of promissory note is quite important. The tax perspective suggest to have a higher sales price for the home and charge the buyer with lower interest rate. This way, one can get his capital gains free from tax on the sale of the home.Only the interest on the note will be taxed. On the other hand,  a low sales price coupled with high-interest rate is good for the buyer since he or she could write off the interest and, once the payment is done regularly for a year or so, then refinance at a lower interest rate by traditional bank mortgage. Ironically, now that the buyer has developed the equity in the home, he or she may not have any issue to secure a financing from the bank to purchase it.

Corporate Credit

Businesses use promissory notes as short-term financing. For instance, when a company sells various products but doesn’t collect payments,  it may run low on cash and find it hard to pay creditors. In this case, company can ask creditor to accept promissory note to be exchanged for cash at a defined future time once it gets its accounts receivables. The alternate option is the bank to get financing.

Promissory notes serve as a source of credit for the companies having no other options, like corporate loans or bond issues. A note given by the company in such situation is at a higher risk of default even than corporate bond. This implies that interest rate on a corporate promissory note tends to offer a higher return than the bond from the same company – high-risk leads to higher potential returns.

These notes must be registered with the government of the state where these are traded with the Securities and Exchange Commission. Regulators review the note to determine company’s capability to meet its promises. If not registered, the investor should personally analyze the company’s ability to service a debt. In such case, the investor’s legal avenues might be somewhat limited in default case.

Investing In Promissory Notes

Investing in the promissory notes, even for take-back mortgage, means risk. To minimize risks, the investors must have promissory note notarized or registered. Also, in take-back mortgage case, the note buyer may take an insurance policy on the issuer’s life.

Conclusion

By removing banks and other traditional lenders in the process, investors in promissory notes take the risk without having the capability to minimize the risk by distributing it over thousands of loans. This risk; however, means larger returns – provided that the payee is not defaulted on the note.

References for Promissory Note

Academic Research on Promissory Note

Schubert’s Promissory Note: An Exercise in Musical Hermeneutics, Cone, E. T. (1982). Nineteenth-Century Music, 233-241.

Stress, NK cells, and cancer: Still a promissory note, Ben-Eliyahu, S., Page, G. G., & Schleifer, S. J. (2007). Brain, behavior, and immunity, 21(7), 881-887.

Vasodilator therapy of heart failure: has the promissory note been paid?, Braunwald, E., & Colucci, W. S. (1984). The promissory note: COP 21 and the Paris Climate Agreement, Christoff, P. (2016). Environmental Politics, 25(5), 765-787.

Is the Promissory Note of Personality as Vulnerability to Depression in Default? Reply to Zuroff, Mongrain, and Santor (2004)., Coyne, J. C., Thompson, R., & Whiffen, V. (2004).

Any Promissory Note: The Obscene Security: A Search for the Non-Commercial Investment,

Rules under the Uniform Electronic Transactions Act for an electronic equivalent to a negotiable promissory note, Whitaker, R. D. (1999).Bus. Law., 55, 437.

May a Promissory Note Be Payable in Foreign Money, Perkins, R. (1919). Iowa L. Rev., 5, 209.

The role of stress management in blood pressure control: why the promissory note has failed to deliver, Hunyor, S. N., & Henderson, R. J. (1996).

Jean-Joseph Goux and the Metaphor of the Promissory Note in Gustave Flaubert’s Madame Bovary, Zrzavy, H., & Reynaud-Pactat, P. (1988).

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