PROMISSORY NOTES: an Overview

Many times, money is loaned and oral promises to pay are made by the person borrowing the money. While oral promises are enforceable in a court of law (and, except to the extent that these types of promises apply to real property, they have the same force and effect as a written agreement), proving what the promise was or is tends to much more difficult if the promise is not reduced to writing - people's memories fade or become faulty, when or how much to be repaid can become confused, one's ability to repay may cause the agreement to "change." As such, if you plan on lending money or valuables to someone -- even if it is a close friend or family member -- it often makes sense to put the terms of the loan, the repayment obligations and the expectations of the parties in writing, to avoid confusion or ill-will later. "Get it in writing" is the function of a Promissory Note.

A promissory note is a written instrument that documents or records a transaction where money is loaned from one party to another. The terms of the loan, the repayment schedule, the interest rate (if any), where the payments are to be made, etc., are included in the note. The note is signed by the person borrowing the money. The note is then kept by the person lending the money as evidence of the loan and the repayment agreement (with a copy usually provided to the borrower).

"Pay to the order of" language is sometimes found in promissory notes (this type of language is seen on personal checks). When this type of language appears in the promissory note (i.e. John Borrower promises to pay to the order of James Lender the sum of ...), the person signing the note (called the maker) is agreeing that he will repay to the lender or the person the lender designates to receive the payments. In other words, the lender can loan the money to the borrower and then direct that the borrower repay the loan to the lender or lender's wife, brother, friend or other person that the lender owes money to. This type of language gives the lender flexibility in designating who will receive the payments on the loan from the borrower.

Cognovit promissory notes are notes that document a loan transaction, but also permit the note holder to obtain a court judgment against the borrower on the note if the borrower does not make payments as agreed in the note - without having to go to a trial. The cognovit provision states that the borrower agrees that such a judgment can be rendered against him without a trial and that the borrower is specifically giving up his right to defend himself in court. However, a few states have passed laws that prohibit the enforcement of cognovit provisions in promissory notes, i.e. they are not legal. Even if the cognovit provision of this type of note is not enforceable in the state where the holder (the person to whom the money is to be paid by the person signing the Cognovit Note) resides, the note itself will still generally be enforceable and can be sued upon should the person signing the note miss any payments.

Some promissory notes provide for personal guarantees - if the person borrowing the money is a corporation or is an individual that does not appear to have a solid financial base, another individual will be required to sign the guarantee, thereby promising the lender to pay the loan if the borrower does not. These provisions are enforceable and will bind the person signing the guarantee in the same manner as the person who signed the note.

The requirements of how a promissory note must be signed are governed by state law and varies from state to state. Some states require that a promissory note by witnessed, others require that it be notarized and some do not require witnessing or a notary.

In some cases, a promissory note is used when a loan is made for the purchase of real property. When this type of loan is made, the person lending the money often takes a mortgage on the property. That is, the borrower agrees (through a written document that is recorded with the local recorder's office) that the lender has an interest or lien on the property until such time as the loan is repaid in full. If the loan is not paid in full, the mortgage holder can file a lawsuit, usually called a foreclosure, seeking to have the property sold and the proceeds generated from that sale paid to the lender to satisfy or pay off the loan.

In cases where a loan is used for the purchase of specific personal property (i.e. property that is not land or real estate), a similar type of document can be used to secure the loan or to specify collateral for the repayment of the loan. A security interest can be obtained in the property that is purchased with the borrowed money - this is referred to as a purchase money security interest. If property other than the property purchased with the money is offered as collateral or security on the loan, this type of security is referred to as a non-purchase money security interest. The document that identifies these types of security interest is called a Security Agreement. This document sets forth the details on the type of collateral, location, and how the collateral is handled should the borrower not repay the loan as agreed.

DISCLAIMER REGARDING LEGAL ADVICE: None of information contained on this web site is intended to constitute legal or other professional advice, and you should not rely solely on the information contained on the site for making legal decisions. When necessary, you should consult with an attorney for specific advice tailored to your situation.