Law of Promissory Notes
A promissory note is a promise-to-pay document or oral agreement that lenders request from someone borrowing money.
The promissory note is a legal binding contract that requires a borrower to follow the terms agreed upon by both the lender and borrower. Not following the terms of the promissory note can make the contract invalid, and in some cases, the loan plus any penalty fees may have to be paid in full instead of payment arrangements.
Oral vs. Written
A promissory note can be written or oral. An oral agreement is made verbally between the lender, borrower and other parties. An oral agreement is still legally binding, even if no paperwork is signed.
An oral promissory note may be more difficult to prove because the promise to pay is not in writing. To avoid confusion or ill-will, it is easier to put the obligations and expectations of the parties in writing.
Cognovit Promissory Notes
A cognovit promissory note not only documents the loan transaction, but also allows the lender to obtain a court judgment against the borrower on the loan if the borrower does not repay the loan as agreed without going to a trial. This note states that the borrower agrees that the judgment can be rendered against him without going to trial, and that he is giving up his right to defend himself in court. In some states a cognovit promissory note is illegal.
Some promissory notes can have what is called an acceleration clause. With this the loan payments are due every month or whatever the repayment terms specify. If a payment is missed, under the acceleration clause, the agreement made in the original promissory note is invalid, and the entire loan amount is due in full.
A personal guarantee promissory note is necessary if the person borrowing the money is a corporation or does not have the financial means.
The personal guarantee requires another individual to sign the promissory note, guaranteeing the loan. The individual guaranteeing the loan then assumes the responsibility of paying the loan in the event the original borrower does not make the payments.
Unsecured Promissory Note
A lender should be careful when lending money through an unsecured promissory note, and the lender should be prepared to lose money in the event the loan is not repaid.
If the borrower declares bankruptcy, the secured creditors are paid before any unsecured creditors. This is legal for bankruptcy courts to do; therefore, it is wise for lenders to file security for the loan, such as a lien or mortgage against the loan, or recognition of the loan on title to title property.