It's not wise to default on a promissory note. A promissory note, or promissory letter, is a legal instrument that provides the details of a contractual agreement between two parties. A promissory includes all the terms of repayment, including the rate of interest, the due date, and the number of payments to be made. This is different from an IO in that an IOU denotes that there is an outstanding debt but does not include the terms of repayment.

What Is a Promissory Note?

A promissory note becomes a legally binding agreement when the parties agree to the terms and sign the note. "Legally binding" means that each party agrees to a number of conditions and is willing to perform according to the terms. A contractual arrangement that includes many details and issues requires a more complex promissory note, whereas a basic, straightforward arrangement would necessitate only a simple promissory note. This allows a promissory note to be a very flexible document.

In the event that one party does not fulfill their obligations, a promissory note serves as a signed legal document to help remedy the contract breach. Promissory notes are often used when a customer wants to make a purchase but does not have the cash on hand to pay. The note obligates the customer to pay for the item as agreed in the terms of payment.

Banks, businesses, and individuals may lend money to borrowers and have them sign a promissory note. The note includes the terms of the loans. If the loan terms and conditions are long or complex in nature, a separate loan agreement may be provided.

For a promissory note to be enforceable, it must contain four components:

  • Parties
  • Promise
  • Sum certain
  • Signatures

Parties

The party or parties in the transaction are the person(s) or business entity(ies) directly involved or interested in the transaction. The party who draws the note is often referred to as the "maker," "drawer," or "promisor." The "drawee" or "payee" is considered the person in whose favor the promissory note is drawn.

A promissory note must list a current address and general information for all parties involved. All parties involved must be of legal age and of sound mind to sign a promissory note.

For example, if someone is not listed on a vehicle title or does not have power of attorney, they do not have the legal authority to enter an agreement by way of promissory.

Promise

The terms and conditions should define the promise. The promise should clearly express the specific sum of money promised and the exact terms of the agreement. Do not include alternatives such as yard work or housecleaning chores as a form of payment. This often complicates enforceability in legal proceedings if the agreement is broken.

Sum Certain

The amount to be paid along with the interest, appreciation, and details of nonpayment penalties should all be included in the sum certain component of the promissory note. A schedule of payments is often listed in the sum certain part of a mortgage promissory note. This section usually breaks down how much payment will go towards the principal and how much will go toward the interest at each scheduled payment.

Signatures

Without signatures, the promissory note is not a legally binding document. The lender should verify the identity of each party prior to acquiring signatures. This is most often achieved by requesting a photo ID such as a driver's license.

What Should a Promissory Note Include?

The number of payments to be made over a determined amount of time should be clearly defined and explained in a promissory note. A promissory note may include a default on secured debt as part of the agreement. This means that if the borrower fails to pay under the agreed-upon terms of the promissory note, then the lender can take the secured debt as a form of payment.

For instance, when car dealerships sell a vehicle, the dealer will often secure the debt by adding in vehicle promissory note that states that if payments are not made as agreed, then the dealer has the right to repossess the vehicle. This is known as a secured promissory note.

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