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If you've taken out a student loan, mortgage or personal loan, you've likely signed what's known as a promissory note. By signing a promissory note, a borrower promises to pay back a set amount of money, including interest and fees, to a bank, a person or another lender.
How Does a Promissory Note Work?
A promissory note is a written, legally binding loan document. It gives the lender a way to enforce the loan agreement. If the borrower were to stop making payments, a promissory note proves the borrower agreed to the initial terms of the loan and understood their responsibility to repay the loan according to those terms.
The wording of a promissory note can vary from lender to lender. However, promissory notes normally cover much of the same basic information, such as the loan's dollar amount, interest rate and repayment term.
Some common language you're likely to see in a promissory note includes:
- Names of the parties: The note lists the names of the borrower and lender.
- Principal amount: This is the dollar amount of the loan. This may not be the actual amount you receive as a lump-sum payment, however, as many lenders subtract fees before issuing the loan to you.
- Interest rate terms: The note should lay out the interest rate that's being charged and how the interest rate is being calculated.
- Payment schedule: The document should spell out when payments are scheduled to be made and the minimum amount of each payment (including interest).
- Loan term: This is how long the borrower has to pay off the loan.
- Late payment penalties: The note may explain when a payment is considered late and what the penalty is for a late payment.
- Default clause: This clause dictates when a loan is deemed to be in default. For instance, the loan might be in default if a specified number of payments are made a certain number of days past the due date.
- Acceleration clause: This clause gives the lender permission to demand payment of the full amount owed if the loan is in default.
- Collection costs: This section of a note explains that the borrower must pay all legal expenses if the lender takes them to court.
- Assignment: The document may let the lender sell the loan to another lender, assigning the note's legal rights to the new lender.
A very basic promissory might outline loan terms as follows:
- Loan amount: $25,000
- Interest rate: 5.8%
- Repayment period: 10 years
- Monthly payment: $275.05
Types of Promissory Notes
Several types of promissory notes can be written. They include:
- Open-ended note: This type of note covers a line of credit, enabling someone to borrow money over time up to a set dollar limit. The amount of money available to borrow fluctuates based on how much has already been borrowed and repaid.
- Installment note: This kind of note sets up a schedule for paying off the principal and interest for installment credit.
- Simple note: Under a simple note, a borrower must pay off the entire loan in one lump sum.
- Demand note: With this type of note, a lender can demand that the full loan amount be paid at any time.
- Investment note: Through this type of note, a company borrows money from an investor. In return, the investor is promised a set amount of period income.
- Secured note: A secured note is backed by collateral, such as real estate.
- Unsecured note: An unsecured note is not backed by collateral.
- Convertible note: This type of note represents short-term business debt that at some point can be converted into equity in a company.
Pros and Cons of Promissory Notes
As with any sort of legal agreement, a promissory note comes with pros and cons.
Pros of Promissory Notes
- A promissory note is legally stronger than an informal IOU or verbal agreement.
- A promissory note can offer assurance to lenders you know personally, such as relatives and friends, that you will pay back the loan.
- A promissory note outlines loan terms, so there's clarity on your responsibilities as a borrower, as well as what the loan will ultimately cost you.
Cons of Promissory Notes
- A promissory note may be less formal, and may not stand up to the same legal scrutiny a standard loan contract would.
- A lender might have less power to seize a borrower's property if the loan goes into default than if the loan is covered by a standard contract.
- A borrower using a promissory note may pay a higher interest rate than if they got money through a more formal lending arrangement.
Promissory Notes and Your Credit Reports
Details of a promissory note may or may not show up on your credit reports. If the lender that issues the loan is able to report the borrower's payment history to credit reporting agencies―Experian, TransUnion and Equifax—this activity generally will show up on the borrower's credit reports.
However, only traditional lenders and investment firms typically report such information to credit reporting agencies. Therefore, information about a promissory note may never appear on your credit reports.
The Bottom Line
When you're planning to borrow money, it's wise to check your free Experian credit report and free Experian credit score. By doing so, you can see whether your finances are in the best shape to qualify for an attractive interest rate and other desirable lending terms.