A promissory note is a financial instrument that includes a written promise by one party (the maker or issuer of the note) to pay another party (the payee) a specific sum of money on demand or on a certain future date—similar to a loan agreement. A promissory note is similar to an IOU but a promissory note is much easier for the lender to enforce, as it is in writing and should contain the essential terms of the loan and the borrower’s obligation to pay the debt.
A promissory note typically includes important terms related to payment of the debt, including the principal amount of the debt, the interest rate that will apply, the monthly payments that will be made (if that is the agreed method of payment), the maturity or due date of the promissory note, the date and place where the promissory note was made or issued, and the signature of the maker or issuer who is obligated to pay the debt.
A promissory note can be secured or unsecured. For example, the lender may require the borrower or maker of the promissory note to put up collateral or assets that the lender may seize or “execute on” if the borrower fails to pay the debt described in the promissory note (a secured or collateralized promissory note).
Or the lender may not require the borrower or maker of the promissory note to put up such collateral (an unsecured promissory note), being confident that (1) the borrower or maker will pay the debt or (2) if the borrower or maker fails to pay the debt, the borrower or maker has sufficient assets that the lender will be able to file a lawsuit and seize those assets to satisfy the debt.
A person who takes out a personal loan at a bank or other financial institution may be required to sign a promissory note. Promissory notes are also used by companies to raise or borrow money from a source other than a bank—but often at higher interest rates.
Investing in Promissory Notes
Investors sometimes loan money to a company and the company makes or issues a promissory note to the investors. In return for the money the investors loan to the company, the company promises the investors (through the promissory note) a fixed amount of periodic income in the form of monthly principal and interest payments on the loan or debt, for example. Typically, the rate of return promised to the investors is very high—and the level of risk promised is very low.
Promissory notes can be appropriate investments for many investors. But promissory notes that are sold broadly to individual investors are often scams.
What you can do to avoid promissory note fraud:
• Typically, promissory notes are securities. They must be registered with the SEC, a state securities regulator, or be exempt from registration. Most legitimate promissory notes can be easily verified by checking the SEC’s EDGAR database or calling your state securities regulator.
• The seller must be properly licensed to sell securities. Check your investment professional’s registration status by calling your state securities regulator.
• Compare the rate of return on the promissory note with current market rates for similar investments. Similar investments would be fixed rate investments, long term Treasury bonds, or FDIC insured certificates of deposit. If the seller promises a higher rate, proceed with caution.
• Be cautious if the seller promises risk free, insured, or guaranteed returns. These claims are usually the bait con artists use to lure their victims. Always remember that if it sounds too good to be true, it probably is.