5 min read May 13, 2024

What Is a Promissory Note and How Does It Work?

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Edited By

Megha Mulchandani

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Editor
Edited By

Megha Mulchandani

Editor, Houzeo
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Megha M. is an adept content editor well-versed in the intricacies of American market dynamics and economic trends. In her free time, she excels as a versatile theatre artist and public speaker.

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The mortgage balance in the U.S. rose to $12.01 trillion, with a delinquency rate of 3.8% in Q4 of 2023. This is because many homebuyers either lost their jobs or expired during the pandemic. To safeguard themselves from potential defaults, lenders ask borrowers for a promissory note.

A promissory note is a legal document in which the borrower promises to repay the lender. A collateral is not always needed to support the document. The document outlines the amount to be repaid, the interest, the due date, and the repayment schedule.

As a first-time homebuyer, it’s important to be well-versed with terms like promissory notes before you start your mortgage journey. Start here, and shop for lenders online.

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How Does a Promissory Note in Real Estate Work?

A promissory note works as a documented commitment of the borrower that they will repay the loan to the lender. The note obligates the borrower to pay the lender within a fixed timeline.

On the other hand, the note also obligates the lender to enforce their right to foreclose the borrower’s property, if they fail to repay.

The purpose of the note is to assure the lender that they will be repaid. In real estate, a promissory note is also termed as mortgage note.

Types of Promissory Notes

Here are some common types of promissory notes:

1. Secured Promissory Notes

A secured promissory note is backed by collateral. It is a legally binding document that outlines the terms of a loan. It includes the borrower’s promise to repay a specific amount, plus interest, within a predetermined timeframe.

2. Unsecured Promissory Notes

An unsecured does not have any specific asset or collateral tied to it. It is a legally binding document that outlines the following:

  • Terms of a loan
  • The place where the borrower promises to repay a specific amount, plus interest
  • Timeline in which the borrower promises to repay

3. Master Promissory Notes(MPN)

An MPN is a legal document that serves as a binding agreement between a borrower and a lender. It is used in the context of student loans. It outlines the terms and conditions of the loan and is valid for a specified period or multiple loan disbursements.

MPN streamlines the loan process for borrowers, as it ousts the need to sign separate promissory notes for each loan disbursement. It provides a standardized framework for loan terms, ensuring consistency and clarity in the borrower-lender relationship.

What Does a Promissory Note Contain?

A promissory note generally mentions the terms and conditions of a loan. Here’s a list of particulars that a promissory note typically contains:

  • Parties Involved: The note identifies the parties involved in the loan transaction, the borrower and the lender.
  • Date: The note mentions the date of drafting of the promissory note.
  • Principal Amount: It states the amount borrowed by the borrower, known as the principal sum.
  • Interest Rate: The note specifies the interest rate, which can be fixed or variable.
  • Repayment Terms: It outlines the repayment terms, including its schedule, and the due dates. Also, it includes information on any grace periods before late fees or penalties.
  • Maturity Date: The note specifies the maturity date by which the loan must be repaid.
  • Prepayment Provision: The note may include prepayment provisions. This allows the borrower to pay off the loan before the maturity date. Also, it outlines any prepayment penalties or conditions, if applicable.
  • Late Payment Fees and Penalties: The note may include provisions for late payment fees or penalties.
  • Collateral (if applicable): If the loan is secured, the note may include details about the collateral pledged as security for the loan.
  • Governing Law: The note specifies the laws that govern the promissory note.
  • Signatures: The note requires the signatures of both the borrower and the lender. The signatures indicate their agreement to the terms and conditions stated in the note.

Why Do Lenders Use Promissory Notes?

Lenders use promissory notes for the following reasons:

  • Legal Protection: Promissory notes provide clear proof of the borrower’s promise to repay the loan and the lender’s rights and remedies in case of default.
  • Establishing Loan Terms: Promissory notes outline the terms and conditions of the loan like the repayment schedule, interest rate, and any applicable fees or penalties.
  • Evidence of Debt: Promissory notes serve as evidence of the debt owed by the borrower to the lender. They provide documentation of the loan amount and the borrower’s promise to repay it.
  • Enforcing Repayment: In the event of default by the borrower, a promissory note helps the lender pursue legal remedies to enforce repayment. It establishes the lender’s rights to pursue collections, take legal action, or initiate foreclosure or repossession proceedings.
  • Transferability: Lenders can transfer or sell promissory notes to other parties. The note proves the lender’s ownership and the borrower’s obligations, facilitating the transfer process.

Bottom Line

Lenders use promissory notes as essential legal documents that protect their interests. This includes final loan terms and a clear record of the borrower’s repayment obligations.

Promissory notes also serve as evidence of the debt, enable repayment enforcement, and facilitate loan transfer.

Moreover, with promissory notes, lenders can ensure legal protection, maintain documentation, and effectively manage their lending relationships with borrowers.

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Frequently Asked Questions

Can promissory note be signed electronically?

Yes, promissory notes signed under RCW 62A can be signed electronically.

Can I write my own promissory note?

Yes, you can write your own promissory note. Consult with an real-estate agent to know how to frame it.

Who issues promissory note?

Banks, mortgage lenders, and credit unions issue a promissory note.

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