What is a Promissory Note in Real Estate?

When you buy a home or property, you might hear about something called a “promissory note.” This is a simple document that says the borrower (the person taking the loan) promises to pay back the lender (the person giving the loan). It explains the loan terms, like how much money is being borrowed, when it will be paid back, and if there’s any interest.

In this article, we’ll explain what promissory notes are, why they’re important, the different types, and how they compare to other legal documents, like mortgages.

What Is a Promissory Note?

A promissory note is a written promise to pay back money that was borrowed. It’s like a formal IOU. It includes details like:

• The amount borrowed.
• The repayment schedule (when and how the money will be paid back).
• Any interest the borrower has to pay.

In real estate, promissory notes are used to spell out the loan terms when someone borrows money to buy a property. This helps make sure both the borrower and lender understand and agree to the financial deal.

Important: A promissory note is more formal than an IOU but simpler than a big loan contract.

History of Promissory Notes

Promissory notes date from the Code of Hammurabi (1754 BC) in Mesopotamia. Laws defined terms for repayment of loans and necessity of written agreements. Promissory notes were made of leather during the Han dynasty in China (118 BC) for use in trade. The earliest evidence of promissory notes was found in ancient Rome on Bloomberg tablets dating to 57 AD.

Promissory notes became popular in Europe during the medieval period. The Knights Templar developed a precursor to modern promissory notes. This way pilgrims could deposit their valuables and later retrieve equivalent funds in the Holy Land. By the 14th century, promissory notes were in use for trade across various cities like Genoa, Barcelona, and Valencia. This served as an alternative to carrying large sums of metal coins.

In the US promissory notes became part of financial and real estate transactions. With the advent of digital technology, the Electronic Signatures in Global and National Commerce Act (2000) and the Uniform Electronic Transactions Act (UETA) enabled the introduction of eNotes, or electronic promissory notes. These digital instruments meet all the legal requirements of traditional promissory notes for modern business and real estate transactions.

What Purpose Does the Promissory Note Serve?

Here are the main purposes of a promissory note:

Clarity in Financial Terms: The promissory note spells out the loan amount, interest rate, payment schedule and other conditions so there’s no confusion.

Legal Protection: It’s evidence of the borrower’s obligation to repay, protects the lender’s interest in case of a dispute or default.

Loan Tracking: Both parties can track payments and outstanding balances.

Complement to Collateral Agreements: In real estate, a promissory note often accompanies a mortgage or deed of trust, linking the repayment terms to the collateral (property).

Types of Promissory Notes

1. Secured Promissory Note

A secured promissory note is backed by collateral, like real estate, vehicles or other valuable assets. This reduces the lender’s risk as they can take the collateral if the borrower defaults on the loan. Secured notes are common in real estate transactions where the property is the collateral.

2. Unsecured Promissory Note

Unlike secured notes, unsecured promissory notes have no collateral. The lender is relying on the borrower to pay back. While easier to execute, unsecured notes are riskier for the lender and often have higher interest rates to offset the risk.

3. Master Promissory Note

A Master Promissory Note (MPN) is a long term agreement that allows borrowers (students in this case) to borrow multiple loans over a 10 year period under one document. Borrowers must sign a separate MPN for each loan type, whether for federal direct loans for undergraduate or graduate students.

4. Demand Promissory Note

A demand promissory note allows the lender to request repayment at any time. While it gives the lender flexibility, the borrower must be prepared to pay back the loan on short notice. This is good for short term borrowing or lending arrangements with uncertain repayment terms.

5. Convertible Promissory Note

Used in business or investment financing, a convertible promissory note gives the lender the option to convert the debt into equity, like company shares, under certain conditions. This is less common in real estate but useful in ventures where the lender sees ownership benefits.

6. Balloon Promissory Note

A balloon promissory note has smaller payments during the loan term with a large lump sum payment (the “balloon payment”) at the end. This is common in real estate and allows borrowers to manage lower payments initially and often with the expectation of refinancing or selling the asset to pay off the final payment.

What’s Included in a Promissory Note?

• Borrower and Lender Information: Full names and contact details.
• Loan Amount: Principal amount borrowed.
• Interest Rate: Fixed or variable rate applied to the loan.
• Prepayment: Are you allowed to do a prepayment?
• Repayment Terms: Schedule and method of repayment (installments or lump sum).
• Maturity Date: Deadline for full repayment.
• Collateral (if applicable): Assets pledged to secure the loan.
• Default Terms: Consequences of non-payment.
• Signatures: Both parties’ signatures to validate the agreement.

How Do Promissory Notes Work in Real Estate?

In real estate, a real estate promissory note is a key part of the financial process when buying a home. It’s a written agreement where the borrower promises to repay a loan under specific terms, including the loan amount, interest rate, repayment schedule, and maturity date. While the real estate promissory note is just one document in the process, it serves an essential purpose.

Along with a mortgage, the real estate promissory note establishes the borrower’s obligation to repay the loan. The mortgage secures the promissory note by using the property as collateral. If the borrower defaults on the loan, the lender can foreclose on the property to recover the owed amount.

At closing, you will sign both the mortgage and the real estate promissory note. The lender keeps the original note until the loan is fully paid off, while you receive a copy of both documents and other closing paperwork. This ensures that the loan agreement is legally binding and protects both the lender and borrower throughout the repayment period.

What’s the Difference Between a Promissory Note and a Mortgage?

People often use these two terms interchangeably. But there are a couple of major differences between a promissory note and a mortgage.

Purpose: A promissory note is a written promise to repay a loan, outlining the amount, interest, and terms of repayment. A mortgage is a security agreement that gives the lender a lien on the property, ensuring the loan is backed by collateral.

Transferability: Promissory notes can be transferred or sold to different lenders. Mortgages generally stay tied to the property until the debt is satisfied or refinanced.

Enforcement: If a borrower defaults, the lender can sue based on the promissory note for repayment. With a mortgage, the lender can foreclose on the property to recover the debt.

What Are the Pros and Cons of a Promissory Note?

Pros

Promissory notes offer flexibility in structuring repayment terms, making them suitable for a wide range of borrowing needs. They allow for customized agreements, including fixed or variable interest rates, secured or unsecured arrangements, and repayment schedules tailored to both parties.

For borrowers, promissory notes can serve as an alternative to traditional loans, especially when securing financing from a bank or other traditional lender is not an option. For lenders, they provide a legally binding document to ensure repayment, offering clarity and protection in the transaction.

Cons

Despite their simplicity, promissory notes can carry significant risks. For lenders, unsecured notes lack collateral, making recovery difficult if the borrower defaults. For borrowers, terms can include high-interest rates or strict repayment conditions, especially in unsecured arrangements. Additionally, without proper documentation or legal advice, disputes may arise regarding the note’s enforceability.

FAQs About Promissory Agreement

Can a Promissory Note Be Used as Collateral?

Yes, a promissory note can be used as collateral, specifically when it is classified as a secured promissory note. This type of note is backed by an asset or property that the borrower pledges to the lender, providing security for the loan. If the borrower fails to repay the loan, the lender has the legal right to seize the collateral to recover their investment.

When To Use a Promissory Note?

A promissory note is ideal in situations where clear and legally binding documentation of a loan agreement is necessary. Common scenarios include:

• Personal Loans: When lending money to friends or family to avoid misunderstandings.
• Business Transactions: For loans between businesses or to secure investor funding.
• Real Estate: As part of seller financing arrangements or private mortgage agreements.
• Alternative Financing: When traditional loans from banks are unavailable or unsuitable.
• Short-Term Borrowing: For temporary financial needs with a defined repayment period.

Where Can I Get a Promissory Note?

You can obtain a promissory note through various sources, including:

• Legal Professionals
• Banks or Financial Institutions
• Business Advisors
• Software Tools like Dedicated apps and platforms