A promissory note can be an excellent way for both lenders and borrowers to benefit from a loan. A secured promissory note is a binding agreement between two parties, which guarantees repayment on an advance of funds. It is considered more potent than an IOU, but not always as strong as a formal loan agreement that you may get at a bank or another lending institution.
Promissory notes serve to mitigate the risk that the lender takes when they extend loan offers to borrowers in need. By having a binding document in hand, the lender has legal recourse to recoup any money lost due to nonpayment.
At a corporate level, loans secured by promissory notes can be a great investment opportunity for companies. However, those loans are typically substantial and are required to register with the SEC. You may also see promissory notes used during the closing stages of a house purchase when the borrower is seeking a mortgage.
Secured vs. Unsecured
There are two types of promissory notes – secured and unsecured. There are benefits to each, and you must decide which type of agreement works for your particular situation.
A secured note is also known as a promissory note with collateral. It is an agreement in which the borrower offers collateral, which can be claimed by the lender in the event of nonpayment. This collateral can take the form of a vehicle, real estate, or other valuable assets. The asset in question should always be equal to or greater than the value of the loan.
Any type of collateral does not guarantee unsecured promissory loans. Because those loans are typically riskier, they come with a higher interest rate to protect the lender. Typical unsecured loans that you may see are student loans and credit cards.
How to Create a Binding Promissory Note
If you are considering lending a sum of money, it’s recommended to create a promissory note in the event of default. To do this, you can find a secured promissory note template which provides the details of the loan, and explicitly lists the asset being put up for collateral. If the borrower defaults, you have a legal document that entitles you to claim the borrower’s property as repayment.
Here are the steps for creating a reliable document which will protect you as a lender:
- Decide whether you want the note to be secured by collateral, or unsecured.
- Use a secured promissory note template as a starting point for creating your own document.
- Fill in the details of the template as thoroughly as possible
- Provide identifying information about the borrower and lender
- Define the due date of the loan and the terms of repayment
- Include information about any interest that may accrue during the loan term
- Specify whether there will be installment payments or one lump sum repayment
- Determine the penalty for late repayment, and the amount of time that must pass before the borrower can claim the secured collateral
- Properly execute the document by having it signed and countersigned by the borrower and lender.
Frequently Asked Questions
Promissory notes do not need to be notarized for them to be legally enforceable, as long as both parties have provided their signature on the document.