What a Promissory Note Is in Real Estate
A promissory note is simply a "promise to pay." It contains a maker (the payor) and a lender (the payee). An unsecured promissory note is not attached to anything, the loan is made based on the maker's ability to repay. Like a handshake but a bit more formal. A secured promissory note may also be made based on the maker's ability to repay, but it is secured by a thing of value such as a car or a house.
If your home is used for security and you default on the promissory note, you could lose your home. Most promissory notes attached to a property are secured by either a trust deed, also known as a deed of trust, a mortgage or a land contract, and those instruments are recorded in the public records. Promissory notes are generally unrecorded. Is an instrument of value. If the payee loses the original prom note, you might have to get insurance. It's a big hassle and expensive.
Borrowers who fail to repay an obligation to which an item of value is used as security could involuntarily lose that security. For example, I had an ex-husband, well, several, and one of them asked me to cosign a promissory note so he could buy a car. When he stopped making the payments, the lender called me to ask for payment. I learned a valuable lesson. Do not co-sign a promissory note, especially if you're married to a deadbeat.
Drawing Your Own Promissory Note
Every state has its own laws about the essential elements of a promissory note. You should never attempt to draw your own promissory note if you ever want to have a chance to collect should the payments stop. Some people think a promissory note is so simple that they can create their own or download a form they found online. If the debt is important enough to you to want to be repaid, it is important enough to hire a lawyer to prepare a promissory note for you.
There are also usury laws that could affect a promissory note, which is the maximum rate of interest that may be charged to a borrower, and the IRS has something to say about promissory notes, too, especially those that charge no interest. If the promissory note is under a certain amount, the IRS can impose its own rate of interest and force the lender to pay taxes on it.
The Essential Elements of a Promissory Note
Most promissory notes involve the following elements, but check with your state laws:
- The Payor of the Promissory Note: This is the person who is obligated and promises to repay the debt.
- The Payee of the Promissory Note: This is the lender, the person or entity that is lending the money.
- The Date of the Promissory Note: The date the promise to repay is effective.
- The Amount of the Promissory Note: The face amount of the money borrowed by the Payor.
- The Interest Rate of the Promissory Note: The interest rate charged. This interest rate can be simple interest or compounded interest among other ways to calculate interest.
- The Date the First Payment is Due and Subsequent Payments: An example of the first payment date might be the first day of the month and every subsequent first date of the following months.
- The Date the Promissory Note ends: This date could be amortized and paid off in a series of even and equal payments on a certain date or it could contain a balloon payment, which would make the entire unpaid balance due on a specific date.
- Terms of Prepayment Penalties of the Promissory Note: Many promissory notes do not contain a prepayment penalty but some lenders want to be assured of a certain rate of return, which could be reduced or eliminated if the payor pays off the promissory note prior to its maturity date. A common prepayment penalty might equal the sum of six months of unearned interest, for example.
At the time of writing, Elizabeth Weintraub, CalBRE #00697006, is a Broker-Associate at Lyon Real Estate in Sacramento, California.