Promissory Note

A promissory note is a written financial instrument in which one party, the maker or issuer, makes an unconditional promise to pay a specified sum of money to another party, the payee, either on demand or at a fixed or determinable future date. Promissory notes are used for business loans, student loans, mortgages, car loans, loans between family members, and sales of goods or property on credit. They create a legally enforceable debt and are more formal than an informal IOU or an ordinary trade account.

The general features of notes as financial instruments are described in the entry on the note. A promissory note differs from a bill of exchange: in a note, the maker promises to pay; in a bill, the drawer orders another party to pay. In the United States, negotiable promissory notes are governed by Article 3 of the Uniform Commercial Code (UCC).

• The names of the maker and the payee, and the date of issue.
• The principal, the amount borrowed or owed.
• The interest rate, fixed or variable, and how interest is calculated, subject to state usury limits.
• The maturity date or repayment schedule, or a statement that the note is payable on demand.
• Any collateral securing the note, which makes it a secured note, and any personal guarantee from a guarantor.
• Provisions on late fees, prepayment, events of default and acceleration, which lets the holder demand full repayment if the maker defaults.
• The maker's signature.

To be negotiable under the UCC, a note must be an unconditional promise to pay a fixed amount of money, payable to order or to bearer, on demand or at a definite time. A negotiable note can be transferred by endorsement, and a holder in due course may enforce it free of many defences the maker might have against the original payee.

A small manufacturer buys a used machine from a supplier for $15,000, signing an 18-month promissory note at 9 percent simple interest, with principal and interest due at maturity. The interest due is:

Here $P$ is the principal of $15,000, $r$ is the annual rate of 0.09 and $t$ is the term in years, 1.5. Interest is $15,000 times 0.09 times 1.5, or $2,025, and the amount due at maturity is $17,025.

The manufacturer, as maker, records the machine at $15,000 and a note payable of $15,000. At each period end it accrues interest expense, for example $1,350 after the first year, and at maturity it pays $17,025, clearing the note and accrued interest. The supplier, as payee, records a note receivable of $15,000 and recognizes interest revenue as it is earned. If the note were due within one year, both parties would classify it as current; here, at the start, it is noncurrent until the final six months.

Notes that carry no interest or an unusually low rate, especially when given in exchange for goods or property, must be recorded at present value under US GAAP, with the difference treated as interest over the term. Notes may be sold or pledged to banks to raise cash, a practice called discounting. Lenders typically perform credit checks, and businesses lending to customers or employees should document the terms clearly, since enforcing an unwritten loan is harder. Interest on loans between related parties may need to meet minimum rates set by the IRS to avoid imputed interest for tax purposes. In consumer lending, a promissory note is often accompanied by a security agreement or mortgage and forms part of the broader loan contract, and borrowers who default face collection, repossession of collateral or legal action.