Promissory Note

A promissory note – is one of the debt instruments, allowing one entity to borrow money from the other one under stated conditions. The first one is usually called the maker, or issuer, the other – is the payee, or receiver. In general, anyone can be the issuer of the promissory note, e.g., a bank, company or even an individual. This note, as its name implies, is a written form of an unconditional promise to pay the debt. The terms of payment can be decided individually. The payee can repay the debt on demand or by a specified date.

Typically, the document states the principal, or initial amount of borrowed money, interest rate, initiation and execution dates, maker’s signature, etc. Although the essential information on the debt is established, the promissory note isn’t as formalized as a loan contract, which always defines the conditions of the borrower’s inability to pay the debt in time or pay it at all, e.g., the conditions of a foreclosure. Nevertheless, the note is organized stricter than an IOU.

Roots of the Promissory Notes

The promissory notes have been existing for a long time since ancient times. The first analogue of the current version was found in China in 118 BC. At some point these notes even became a kind of private currency. And in some ways they still are in the form of demand notes, although they are extremely rare.

The demand note is a type of promissory note that has no fixed time limits or schedule of repayment. These notes were issued in the second half of the 19th century in the United States. Nowadays, the demand note saves some of its initial characteristics like absence of restricted terms and schedule of payments, but obtains a more contemporary form. The demand note is less formal, thereby it is mostly used among relatives, friends, and, overall, someone familiar and trustworthy.

Promissory Notes and bills of exchange differences

The promissory note is not the only type of debt instruments. We slightly compare it to the IOUs and loan contracts in terms of legal formalization of these documents. Another similar debt instrument is a bill of exchange, which appears to be a written form of debt arrangements too. Both of the documents – the promissory note and bill of exchange – are conducted by the Geneva Convention of 1930. However, there are some sufficient differences between them associated with:

• The initiator of the document. The promissory note is drawn by the payee, or receiver, while the bill of exchange – by the creditor, or maker. The note is usually kept by the payee and returned to the maker when the debt is paid back.
• The amount of parties involved. The note includes only two parties mentioned before – the maker and payee, while the bill can include the third party – the acceptor, or drawee. This party pays money to the check owner as an intermediary. Usually, it’s a bank or other financial organization.
• The maker’s liability. The note implies the primary and full liability of the maker, while the bill implies the secondary and limited liability.

More differences can be drawn between these documents, but, basically, the most important difference is that the first one is the promise to pay the debt, while the latter is the directive to pay it.

Types of Promissory Notes

Master promissory note. These notes get a widespread use in the process of arranging a student loan which is a specific type of loan aimed to cover the educational expenses. The private issuer usually requires signing the note each time the borrower gets the education loan. The federal lender, in contrast, allows the borrower to get a master promissory note which can be signed once. This note additionally requires the student’s contact information, employment status, and contacts of his or her references.

Mortgage promissory note. When you take a mortgage – a loan for buying a real estate property – you also sign a kind of promissory note, which is called a mortgage note. This note states your promise to repay the whole amount of debt in time and defines the principal, interest rate, schedule and terms of payments. Also, it can outline the consequences of breaking this promise. The payee holds the mortgage note until the mortgage is paid off.

The promissory note can be used in cases of the buyer's inability to take the mortgage traditionally through a bank. It happens when the bank approves the insufficient sum for the loan. The seller can extend the loan for the buyer in order to close the sale and get extra interest payments. The buyer, in turn, gets an opportunity to purchase a desirable property. This type of mortgage is also known as a take-back mortgage.

The mortgage note, just like any other promissory note, states the payee’s promise to pay off the debt and defines all the required conditions of this repayment. As a precautionary measure, the seller can set a collateral, which provides the security of the loan. In case of the buyer’s default the seller will get the property or another asset stated in the note as the form of compensation to cover the losses.

There is one important consideration towards taxes. For the seller the situation when the prices are high and the interest rates are low is advantageous, while for the buyer it’s vice versa. The first case secures the seller, because the high prices increase the chances of the buyer’s inability to take the loan from the bank. The second one is beneficial for the buyer, because the lower prices are more affordable, and the interest rate eventually can be changed through the refinancing.

Overall, the take-back mortgage possibly can be beneficial for both sides – the seller and buyer – while they follow the undertaken obligations. Both sides are better to consult with a qualified professional beforehand.

Corporate promissory note can be issued by a company due to different circumstances:

• The company can be out of money because of the accounts receivables. This term refers to the money that the company earns by selling its goods or services in advance. In other words, it’s the balance of earned money that is unavailable for the company until the payments get collected. The promissory note can help the company to get the financing for a short period of time in order to stay in business. This note can be exchanged for cash in a bank or can be given as a debt promise to the supplier or another business partner.
• The company can use the promissory notes as a way of drawing investments. These notes are not as safe as the corporate bonds, but they offer higher interest rates. So, some investors are ready to take the risk in order to get noticeable profits. However, if the risks are too high, the registration of the company’s promissory notes in the government or other specified institutions can be denied. Unregistered notes are harder to push on the market, but it’s possible with the help of some brokers that get extra payments for their service.

Investment in Promissory Notes

Investing in the promissory notes involves a lot of risks and requires enough experience in order to take them. Consequently, the promissory notes trading is spread mostly among the companies and experienced investors, who are ready to take the risks in the attempt of getting higher profits in a short-time period. But even the most experienced ones need to take certain precautions like notarization of the promissory note.

Investors can sell these notes on the market. They can be sold fully or partially when the rights for only a certain amount of payments get sold. Also, as bonds they can be sold at a discount because of the inflation’s impact. But, overall, the corporate promissory notes rarely reach the market, because these investments contain too many risks for the market participants.

The main benefit of the promissory notes is the opportunity to get the loan when there are difficulties of getting it traditionally from the bank. However, their main benefit can be outweighed by the associated risks for the lender and borrower.