When you take out a loan, you essentially promise to pay the money back — and you’ll likely sign a promissory note to document that intention.
A promissory note is a written agreement to pay or repay a certain amount of money in a certain period of time. It’s akin to a promise or IOU — but the agreement is a legally binding contract.
In this article, we’ll go over the basics of how promissory notes for personal loans work and when you might come across them.
- When is a promissory note used?
- Different types of promissory notes
- How a promissory note works
- What should be in a promissory note?
- Do I have to sign a promissory note?
When is a promissory note used?
When you get a personal loan, you may have to sign a promissory note — a document that lays out all the terms of the loan, what happens if you don’t repay it on time and what rights you have as a borrower.
With a mortgage, a promissory note is commonly referred to as the “note,” and it’s one of the forms you sign at closing. With other types of loans, including a personal loan, the function is the same.
Different types of promissory notes
Because promissory notes are so common in the lending world, you might come across several different varieties.
Here are a few of the most common.
- Informal promissory note — You might use this when loaning money to friends or family. It’s not a formal document, but like other promissory notes, it should lay out the terms of the agreement including how much money changed hands, when it must be paid back and what happens if you don’t.
- Investments — Promissory notes can also be a type of investment. Companies may issue promissory notes as a form of debt. Investors agree to lend money to a company for a set period of time, and the company agrees to pay the money back with interest. All of this is spelled out in the note. These promissory notes are usually not offered to the general public, but to specific investors.
- Mortgage note — You’ll sign a promissory note when you close on a real estate loan. It lists the details of the mortgage, including when it must be paid and the consequences for not paying.
- Commercial promissory note — These are used for business loans and are often issued by a bank.
- Formal promissory note — This is more of a catch-all category for promissory notes for personal loans, student loans and other types of loans. They’re formal, written contracts that you sign before you receive money.
How a promissory note works
A promissory note is a legally binding document that includes the basics of how your loan works — including how much you owe, how you’ll repay it and what happens if you fail to make your payments. You’ll sign it as part of your final acceptance of the loan.
What should be in a promissory note?
Lenders often have a standard promissory note. Most will include the following:
- Loan amount — This is the total principal amount you’ll owe.
- Interest — This is the interest rate you’ll pay on the loan as well as how the interest is calculated.
- Monthly payments — This is how much you’ll pay every month and a repayment schedule of when the payment is due, including the first payment. The promissory note may also generally cover how you may pay — whether you can pay by check, automatic withdrawal or another method.
- Fees and charges — If there is an origination fee, this will be included along with any late payment fees, insufficient funds fees or other charges.
- Dispute procedures — If you and the lender have a disagreement, the promissory note spells out how disputes will be handled, typically through arbitration (but not always — read the fine print).
- Default — This covers what constitutes going into default on the loan and what happens if a borrower defaults.
Promissory notes for personal loans may also cover what you can use the money for, how the loan money will be deposited into your account, whether prepayments and partial payments are acceptable (and whether there are prepayment penalties), and other legal fine print. Be sure to read the full agreement carefully.
Do I have to sign a promissory note?
In many cases a promissory note will need to be signed to take out a personal loan.
When borrowing from a lender, you’ll typically sign a borrower agreement, promissory note or similar document to lay out the legal terms of the loan.
With an informal loan from a friend or a family member, you may not need to sign one — but even in this case, personal finance experts typically recommend that you put something down on paper.
Even if you’re anxious to get funds from a personal loan into your bank account, be sure to read the promissory note carefully. The note may be multiple pages long, so take your time digesting the entire document and understanding all the info.
If you have any questions, ask your loan rep. Especially with larger loans, you may consider getting an attorney to review the promissory note and make sure the terms are as you expect. Your lender may be willing to adjust terms of the note before you sign.