How To Understand how Promissory Notes Work

A promissory note, in its most legalized form, is a legitimately recognized debt or obligation; a legal agreement from the issuer to the recipient that a certain amount of money will be paid back by a certain date along with a certain rate of return, much in the same way a bank or finance company loans money to an individual, with the individual entering into a legal obligation for repayment of the loan amount plus interest.

Promissory Notes as Formal Investments

Just like loaning money to your ne’er-do-well cousin and expecting to be paid back, a promissory note is only as solid and reliable as the company making the promise to repay.  And, as with all other avenues of financial planning, caution should be exercised and homework done before entering into promissory notes as a means of investment:

  1. All persons selling securities (a promissory note is considered a security) must be either licensed or registered by the state in which the transaction takes place.
  2. With the exception of short-term notes, all promissory notes offered for sale by U.S. entities must be registered with the Securities and Exchange Commission (SEC).  While notes registered with the SEC still aren’t a guarantee of performance, a registered security is verification that the terms of the note in question have held up to SEC scrutiny as a legitimate investment vehicle.  Short-term promissory notes are not required to be SEC-registered and thus should be treated with extra caution.  A short-term promissory note is one with a term of nine (9) months or less.
  3. There is no such thing as a guaranteed rate of return, and no such thing as a guaranteed promissory note.  If a rate of return on a promissory note seems too good to be true, it probably is.  And even an SEC-registered promissory note sold by a licensed securities broker can still fail if the company issuing the note fails.

Promissory Notes Between Individuals

On a smaller scale, a promissory note is any contract or other written agreement which outlines the terms under which a loan is made from one party to another.  At minimum, such a promissory note should encompass the following:

  1. The amount of the loan;
  2. The amount or rate of interest to be paid;
  3. A repayment schedule (i.e., bi-weekly payments, monthly payments, etc.);
  4. The length of the loan;
  5. Signatures of all parties to the promissory note;
  6. Signature notarization.

Signature notarization, while not a hard-and-fast rule, lends added formality to the loan agreement as well as providing an unbiased witness to the promissory note’s execution.  Also, since notarized signatures require the presentation of personal identification, it may preclude an individual from claiming a false signature on the document if small claims court becomes necessary to enforce the terms of the note at a later time.


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