Promissory Notes: What you should know

It would be nice if we never needed anything from anyone. But no person is an island. We all need help from time to time. And sometimes that help comes in the form of a loan, whether to make rent, go to school, buy a house, or a start a business. If so, you’ll frequently have to document that debt through an agreement called a promissory note.

Promissory notes come in several flavors. But each type shares common elements. For example, they normally begin with the date and the party names (the lender and borrower) before discussing the loan terms. The key terms include the interest rate, the amount to be repaid, when and how those payments will be made, and what happens if those payments are not made on time (or at all).

It’s also typical to identify whether the note is backed by collateral. If yes, the note is called a Secured Promissory Note and, if not, it’s known as an Unsecured Promissory Note.

Whether a loan is secured by collateral has a significant effect on the promissory note’s interest rate. That’s for an obvious reason: The interest rate compensates the lender for (among other things) taking the risk that they won’t get paid back. So, unsecured loans have higher interest rates while secured loans have lower ones.

Now that we’ve looked at the skeleton of a promissory note, let’s discuss the four situations where they are often used.

The first scenario is personal loans. Maybe you are borrowing money from family or lending money to a friend. Either way, if the loan amount is high enough, it’s smart to put the loan in writing, especially if you are the lender and worry that the person will later say the money was a gift rather than a loan.

The second type is perhaps the most familiar: A home loan where a homeowner borrows money from a bank to buy their home. The home, in turn, serves as the collateral for the loan.

A third version is commercial loans. For example, a bank might loan money to a company to buy inventory or expand their business. This type of loan often involves significant sums between sophisticated parties, which typically translates into longer, more formal promissory notes or loan agreements.

The final variety is an investment loan where a company raises money from investors. These loans frequently give the investor two ways to get paid back. They can receive their money back plus interest or they can convert their loan into partial ownership of the company. For example, the note could be structured as a $10,000 loan convertible to a 10% ownership stake if the loan isn’t repaid in full within two years.

Now let’s consider five common questions.

First, do I need to put the loan in writing? In most cases, yes. Not doing so invites a host of problems when memories change, people die, or companies file for bankruptcy. But, fortunately, promissory notes need not be complicated, especially for small loans. One or two pages is often enough for a straightforward loan.

Second, what’s the maximum interest rate for a loan? It depends on who is lending the money and how much money is being loaned. Under CNMI law, most people follow one set of rules while banks and a few other licensed financial institutions have a different set of rules. For most of us, the amount of interest that can be charged depends on the loan amount. For small loans ($300 or less), the maximum rate is 24% per year. For larger loans (more than $300), the cap is 12% per year. Licensed lenders, by contrast, can charge higher rates.

Third, what happens if I pay late or not all? It depends on what the promissory note says. But normally, the lender will charge a late fee and increase the interest rate until you’ve paid what you owe. If problems continue and the lender needs to hire an attorney or file a lawsuit, usually the borrower will have to pay for that too. And if the lender doesn’t want to deal with the headaches of trying to collect the debt, they’ll often hire or sell the debt to a debt-collection agency.

Fourth, what happens if the borrower dies before paying off the loan? The debt survives and will become the responsibility of the borrower’s estate (assuming that the estate had timely notice of the debt). In other words, when the borrower’s estate goes through the probate process, the estate will have to pay the lender before the heirs as long as the estate knew or ought to have known about the debt within certain timelines.

Fifth, what happens if the borrower files for bankruptcy before paying off the loan? It depends on the type of bankruptcy and whether the loan was secured or not. But to oversimplify, in many cases a bankruptcy will reduce or even wipe out the loan. Unsecured loans, in particular, fare badly in bankruptcy.

Hopefully this primer on promissory notes helped. But if you have questions, please consult with an experienced attorney about your specific situation.

This column is for informational purposes only and is not intended to be taken as legal advice. For your specific case, consult a lawyer.