A promissory note is an integral part of a mortgage process, in which the borrower agrees to repay the loan to a mortgage lender. Promissory notes are sometimes referred to as mortgage notes, but they are different.
To take the real estate exam, you must learn the definition of a promissory note. For real estate students, it is essential to understand real estate terms to pass the exam.
In this post, I’ll define a promissory note and explain it with the help of an example. After reading this post, you’ll be able to define a promissory note and differentiate it from other notes.
What Is a Promissory Note in Real Estate?
A promissory note in real estate is a written agreement in which the homebuyer promises to repay the home loan to the mortgage lender. It is a legal document that the borrower signs to promise repayment.
A promissory note explains the mortgage term, rates, and monthly payment schedule. The person who promises to make the payment is called the payer, and the person who has to receive the payment is called a payee.
A promissory note for a mortgage includes all the details and terms of a mortgage agreement. This note is a separate document from the mortgage, but it explains the terms of the mortgage. The lender holds on to the promissory note during the mortgage term, and the borrower can request a copy.
Once the borrower makes a final payment, the lending institution marks the original note as paid. After the maturity date, the lender returns the note to the borrower. However, the lender can seize the property if the borrower doesn’t repay the loan. A promissory note includes the following:
- Names and addresses of the borrower and the lender
- The amount of mortgage being given
- In the case of a mortgage, the details of the property as collateral
- The frequency and amount of payments
- Signatures of the borrower and the lender
Requirements of a Promissory Note
Every state has different requirements for the elements of promissory notes. However, the main requirements are always the same for the loan contract, these are as follows:
The name of the person who promises to repay the loan amount.
The name of the person who will receive the payment. This is the person who is lending the money to the payor.
The amount or principal is the loan amount that the borrower promises to pay back to the lender. This is the amount that the payor will pay to the payee.
This is the date on which the promise to repay the loan amount will be effective.
The Interest Rate
The interest rate is the amount at which the payor will repay the loan amount to the payee. The interest rate is the rate that the lender charges the borrower to offer the loan amount. The interest amount is included in the monthly payments along with the principal.
The Due Date
The due date is the date on which the first payment will be due. Mostly the due date is the first day of the month and every first day of the coming months.
The End Date
The end date is the date on which the payee will receive the last payment of the loan.
Types of Promissory Notes
A promissory note is a type of IOU in which the borrower promises to pay off the debt. Promissory notes are of different types, which are as follows:
Secured Promissory Note
This promissory note guarantees repayment with collateral if the borrower defaults on the loan. For a mortgage, the lender can use this note to foreclose the property if the borrower doesn’t repay the mortgage amount.
With a secured note, the property associated with the note is of enough value to cover the mortgage amount. The lender has a guarantee of being repaid by the homebuyer—for example, a person purchasing home signs a secured promissory note and the mortgage.
Unsecured Promissory Note
Unsecured promissory notes are notes that don’t involve any collateral. These notes are enforced in court if the borrower doesn’t repay the loan to the lender. The unsecured notes don’t allow the lenders to secure collateral for the loan. If the borrower fails to make payments, the lender can contact the court to get the money back.
These types of notes are mostly used for short-term loans. Friends or relatives use unsecured promissory notes for borrowing and lending to each other. For example, if a person takes a loan of $10,000 from a bank, they will sign an unsecured promissory note and a loan agreement.
Convertible Promissory Note
A convertible promissory note is a note that converts to equity if it’s unpaid. It is a loan written as a promise by a borrower to the lender to specify the loan amount and the interest on it. This type of note is used for short-term loans expected to convert to equity.
For example, a company signs a convertible promissory note. This convertible note states that a conversion can be made into membership in the company’s shares of stock. After the conversion, the lender will have a share in the stock of this corporation.
Earnest Money Promissory Note
An earnest money promissory note assures that the money has been deposited in good faith on a property sale. The earnest money can be 1% to 10% of the property’s sale price. This legal document binds the borrower and the lender and states the exchange of earnest money between them.
Simple Promissory Note
A simple promissory note includes a lump sum repayment. It states the full amount the lender is giving the borrower, along with a repayment date. This type of promissory note doesn’t need a payment schedule. The lender and the borrower can decide whether to include the document’s interest.
These promissory notes are an easy option when someone doesn’t want to involve a large financial institution in the loan. For example, people use such promissory notes with family members or relatives to make lump sum repayments.
Demand Promissory Note
A demand promissory note is a note that requires payment only when the lender demands payment. No date is mentioned on this note, and the borrower must make the loan payment as required.
For example, if a person signs a demand promissory note, they have to make payment whenever the lender demands. If the person fails to make the payment when the lender demands, a default will occur.
Master Promissory Note
A master promissory note is a type of promissory note that can be used across multiple loans. The name ‘master’ comes from the fact that this type of note can be used for auto loans, student loans, and many different types of loans.
Promissory Note Repayment Plans
Promissory notes can include four different types of repayment plans. The repayments can be made in various forms, which include the following:
- Due on demand
A lump-sum payment means the loan can be paid at once to the lender. These types of repayment plans are more common with small loans. The due-on-demand repayment plan is one in which the lender asks for repayment when required. Installment repayment plans state a schedule of repayments in which the payor has to make payments to the payee.
Lastly, a balloon repayment plan includes monthly payments in equal amounts for a definite period and then repaying the remaining amount in one big payment.
Promissory Note vs. Mortgage
A promissory note is a specific document traditionally included in the mortgage process that outlines the borrower’s promise to pay the lender. If it is included in the mortgage process, it is a key element. The document itself is separate from the regular mortgage documentation but is equally important.
Homebuyers must sign two main documents when they purchase a home: a promissory note and a mortgage. A borrower must sign both documents to purchase a home and initiate the mortgage process.
A mortgage will state that the borrower’s property will be foreclosed if they continuously default on the payment. A promissory note is not publicly recorded; hence it is difficult to find. Contrary to that, a mortgage can be found in public records. The following are the main differences between promissory notes and mortgages:
|A promise to repay the loan
|A statement to indicate what happens if the loan is not paid
|Lender keeps it until the borrower repays the loan completely
|Borrower gets it when they completely pay off the loan
|Not publicly recorded
Is it Possible to Have a Promissory Note Without a Mortgage?
Yes, it is possible to get a promissory note without a mortgage. A promissory note provides an easy way out for those who want to avoid more traditional financing. If homebuyers are looking for alternative ways to purchase a home, they can use a promissory note to do so. A promissory note will list the names of the lender and the borrower and all the mortgage terms and rates.
Promissory Note Example
David wants to purchase a home worth $400,000. He has $80,000 saved for a down payment. He applied for a mortgage loan at a bank and received an amount of $320,000 at an interest rate of 6.75%. The mortgage has a term of 30 years.
At the real estate closing, David signed a promissory note. This note stated David’s promise to repay the loan of $320,000 along with the mortgage terms. Besides that, David also signed the mortgage agreement.
The bank can foreclose his home if David doesn’t make loan payments according to the schedule. Based on the terms of the promissory note, the financial institution can also directly pursue David for the mortgage amount.
Frequently Asked Questions
Why Do Lenders Use Promissory Notes?
Lenders use promissory notes to make sure that they can take legal action if the borrower defaults on the loan. In contrast, most homebuyers think that when they pay the mortgage, they actually start owning their home.
It is the promissory note that the lender holds until the end of the mortgage term. They can use this note to foreclose if the borrower fails to make the remaining payments.
Is a Promissory Note the Same as a Loan?
Promissory notes and loan agreements are both legal documents. However, a promissory note is different from a loan agreement. A promissory note states the promise of the borrower that they will repay the loan.
It also includes the loan details, the payer, and the payee. On the other hand, a loan agreement represents what will happen if the borrower will not repay the loan.
What Is the Difference Between a Promissory Note and a Convertible Note?
A convertible note is a type of promissory note. It doesn’t only represent the debt but serves as an additional business purpose. This type of note converts to equity in the future.
What to Know for the Real Estate Exam
A promissory note is a written promise in which the borrower agrees to repay the loan to the lender. It includes the mortgage terms, interest rate, the late charge amount, and more. Only those that sign a promissory note are legally responsible for repaying the loan. There are certain requirements for a promissory note, which include the details of the payor and the payee and the loan amount. If the promissory note is not paid, the lender can choose a debt collector to obtain the payment.
Now that you’ve read about promissory notes in detail, you’ll be able to define it for your real estate exam. Do you want to learn about more real estate terms like this? Go through these easy-to-learn real estate definitions to prepare yourself.