When you take a loan to buy a house, you'll encounter some legal and financial terms that might sound unfamiliar. One of these terms is "promissory note," which you'll hear about if you're using a loan from a lender to fund your home purchase.

A promissory note is basically like a legal promise or where you, the borrower, formally agree in writing to pay back the loan.

Let's break down what a promissory note means in real estate, the various types it can have, and what information it includes.

 

What's a Promissory Note?

A promissory note is a written promise to pay back money for a loan. It includes the amount owed, interest rate when it's due, payment plan, issuance details, and the signer's signature. Banks use them, but regular individuals and businesses can also use them to borrow money from sources outside traditional banks. So, promissory notes let anyone become a lender.

 

Mortgage Note Vs. Promissory Note

Let's discuss the difference between a promissory note and a mortgage note. Every mortgage note is a promissory note, but not every promissory note is a mortgage note.

A promissory note is a written promise where a borrower agrees to repay a loan to their lender. On the other hand, a mortgage note lays out the details of a mortgage, like how much down payment is needed, the loan amount, whether the interest rate is fixed or can change, and if there's a penalty for paying off the loan early.

 

A Brief History of Promissory Notes

Promissory notes have had a pretty interesting past. They've sometimes been used as an alternative currency, operating without government control. In some places, the official currency is a promissory note known as a demand note (which doesn't have a fixed term or maturity date, letting the lender decide when to ask for payment).

The 1930 Geneva Convention of Uniform Law on Bills of Exchange and Promissory Notes sets the rules for promissory notes and bills of exchange. It insists that the term "promissory note" should be in the document, along with an unconditional promise to pay.

In the United States, people often use promissory notes when dealing with mortgages, student loans, or loans from friends or family. Sometimes, businesses issue them to their corporate clients too.

 

Types of Promissory Notes

Promissory notes come in a few types: secured, unsecured, and Master Promissory Notes (MPN).

Secured Promissory Notes

With a secured promissory note, the borrower must protect the loan by using valuable items like a house, condo, or rental property as collateral. This ensures that the loan gets paid back.

Unsecured Promissory Notes

An unsecured promissory note doesn't need any upfront stuff as security, but you still have to pay back the loan. The lender can sue you or pass your unpaid debt to a collector if you don't.

Master Promissory Notes

A Master Promissory Note (MPN) is like a promissory note but with more flexibility. It's a legal document that says you promise to repay the loan amount and interest, sticking to the agreed terms.

The "master" part means you can use this one document for multiple loans. This is often seen with federal student loans. When students take loans each year, they only need one MPN that covers all their loans during their time in school. This saves them from signing a new note every time they take out a loan.

In real estate, things work a bit differently. You need a new promissory note for each new home loan, whether secured or unsecured. So, if you've refinanced your home, you have to sign a new note because a refinance is considered a fresh loan.

 

What's in a Promissory Note?

A promissory note provides details about a loan and how it gets paid back. Besides the borrower and lender names, it might have:

• Borrower and lender addresses
• When it's due
• Amount borrowed
• Payment plan
• Interest rate and how it's figured
• Rules for paying early
• Extra charge for late payments
• What happens if things go wrong
• Changes, exceptions, and the laws it follows

 

How Promissory Notes Work in Real Estate

Promissory notes are just one part of the process when you're buying a home. In closing, it might seem like a simple stack of papers, but each document has a specific purpose.

During the home loan process, you'll sign both a legally binding mortgage and a mortgage promissory note, each serving a different role. The mortgage secures the promissory note with the property title as collateral. This ensures that if the homeowner fails to make their loan payments, the lender can foreclose and sell the property.

The lender holds onto the original promissory note until you've paid off your loan. When you close, you'll get a copy of your mortgage, promissory note, and other closing documents.

Note: If you close on a mortgage online, the promissory note might be called an eNote, but it's essentially the same.

 

Why Lenders Use Promissory Notes

Lenders use promissory notes to have a legal backup in case borrowers don't repay a loan. Some homeowners may think they're done with their mortgage once they've paid it off, but the promissory note makes them stick to their promise. The lender holds onto the note until the mortgage is fully paid. The note allows the lender to foreclose if the homeowner doesn't pay as agreed.

 

Example of a Promissory Note

A corporate credit promissory note is one type of promissory note. In this case, a company usually wants a short-term loan. Suppose a startup is experiencing growth but faces a cash shortage while expanding. In that case, the agreement might say the company repays the loan when it gets money from its customers.

There are various other promissory notes, like investment promissory notes, take-back mortgages, and student loan promissory notes.

 

Pros and Cons of a Promissory Note

Using a promissory note can be practical, but it also has disadvantages.

Pros

• Helpful when traditional lenders, like banks, aren't an option
• Can be a quick and flexible borrowing solution
• Simple documentation process compared to formal loans

Cons

• Riskier due to the lack of financial institution support
• Legal issues may arise if the borrower defaults
• Both the borrower and lender could face challenges in case of payment problems
• Not as secure as loans from established financial institutions

 

FAQs

Want to know more about promissory notes? Check out these FAQs for a quick overview.

When Do People Use Promissory Notes?

Promissory notes come in handy for various situations, like mortgages, car loans, student loans, and personal loans.

Can I Make My Promissory Note?

Yes, you can create your promissory note. It's a good way to tailor it to your specific deal. You can start with a template and, if needed, consult with a lawyer to make sure it's legally sound.

Can I Have a Promissory Note Without a Mortgage?

Absolutely! You can have a promissory note without a mortgage. It's a way for buyers who can't secure traditional financing to still purchase a home using what's known as a take-back mortgage. This setup allows the home seller to loan money to the buyer for their home purchase.

 

The Bottom Line

A promissory note is a written commitment from one party to pay a specific amount of money on a future date. While financial institutions can issue them, individuals or other groups also use these notes to outline the agreed-upon terms of a loan. In a nutshell, a promissory note allows anyone to act as a lender. However, the average investor needs to approach sales pitches for promissory notes with caution and conduct thorough research before jumping in.