What is a promissory note?
A promissory note is a written, signed promise by a borrower to repay a specific sum to a lender, with the amount, interest, and repayment terms spelled out. It's simpler and more one-sided than a full loan agreement: the borrower is making the promise.
It's used for personal and family loans, business borrowing, and seller financing. Under UCC Article 3, a promissory note that meets certain requirements (a fixed sum, payable on demand or at a definite time, signed by the borrower) qualifies as a negotiable instrument, meaning it can be transferred to someone else who then has the right to collect on it.
A note can be secured (backed by collateral the lender can claim on default) or unsecured (just the borrower's promise). It sets the interest rate, which must stay within your state's usury limit, the repayment schedule (a lump sum, installments, or on demand), and what happens on default. A signed note is enforceable and can be used to collect if the borrower doesn't pay.
When do you need one?
Lending money to family or a friend and wanting a clear promise to repay
A business borrowing or lending with simple terms
Seller-financing part of a sale
Documenting a loan with interest and a schedule
A secured loan backed by collateral
Recording repayment of an existing informal debt
What it should include
Parties: the lender and the borrower
Principal: the exact amount borrowed
Interest: the rate, within your state's usury limit
Repayment: a lump sum, installment schedule, or on demand
Late fees & default: what happens if a payment is missed
Security: any collateral, for a secured note
Prepayment: whether the borrower can pay early
Signature: the borrower's, and a witness or notary for larger notes
Secured vs. unsecured
A secured note is backed by collateral, property the lender can take if the borrower defaults, which lowers the lender's risk. An unsecured note is just the borrower's promise, so it's riskier for the lender and usually reserved for smaller or trusted loans. Secured notes should describe the collateral clearly.
Interest and usury limits
Every state caps the maximum interest a lender can charge (usury), and exceeding it can void the interest or the note. Set a rate within your state's limit, or state that the note is interest-free. This is a per-state number your note should respect.
Family loans and the IRS Applicable Federal Rate
A note between family members isn't just a state-law question, it can trigger a federal tax issue too. If you lend at an interest rate below the IRS's Applicable Federal Rate (AFR), the published minimum rate for the loan's term, the IRS can treat the difference as "imputed interest". Taxable income to you as the lender, and potentially a taxable gift to the borrower, under IRC §7872.
There's a common exception for loans of $10,000 or less that aren't used to buy income-producing property, but for anything larger, charging at least the AFR in effect when you make the loan keeps things clean. Setting a real rate on the note, even a modest one, is often simpler than sorting out imputed interest later.
Common mistakes to avoid
Charging interest above your state's usury limit
No clear repayment schedule or due date
Leaving out late-fee and default terms
Not describing the collateral on a secured note
Not signing, or not keeping the signed original
Confusing a promissory note with a full loan agreement when you need two-sided terms
Lending to family below the AFR without accounting for possible imputed interest