What is a promissory note?

A promissory note is a legal document in which a borrower agrees to pay back a loan. Lenders use notes for all types of loans, including mortgage loans, personal loans and car loans. These IOUs serve a greater purpose than just acceptance of debt — they clearly define the terms of these loans to protect both the lender and the borrower.

How does a promissory note work?

A promissory note is a written promise to repay a loan to a specific entity or individual by a certain date. It’s a legally binding document, which means you could be taken to court and sued if you don’t repay the loan.

Lenders use promissory notes when issuing mortgage loans because they legally tie the borrower to the loan itself. You sign the note at the closing. The promissory note describes specific details of the loan, including:

• The principal amount
• The lender
• The interest rate and whether the rate is fixed or variable
• The payment dates and the loan maturity date
• Prepayment penalties (if applicable)
• Loan charges

Once you’ve paid back the loan in full, your lender releases the promissory note to you. This shows that all parties have fulfilled the obligations outlined in the note and that the lender no longer has a lien on the property. You’ll want to save a copy of this documentation in your personal files in case any legal issues arise later.

Promissory note vs. mortgage

You can expect to sign both a promissory note and a mortgage at closing. The promissory note is the promise to repay a loan for a specific property, and a mortgage secures the home as collateral for the loan. The note describes the terms of the loan, including the mortgage lender, the loan amount, the interest rate and the maturity date, while the mortgage describes what happens if you default on the loan.

One key difference between the note and mortgage is the mortgage is filed with the local government and is a public record, while a note is not.

A note is a promise to pay back a loan. A mortgage ties a property as collateral to a loan.

Like other investments, mortgages can be bought and sold among lenders. Often, you’ll sign a mortgage with one lender only to find that it’s been sold to a new one later — your loan terms won't change, however.

Even when your loan changes hands, though, you’re still obligated to make monthly payments on the mortgage.

Promissory note vs. deed of trust

While a note and mortgage make up an agreement between the lender and the borrower, a deed of trust is an agreement between the lender, the borrower and a trustee. The trustee is a neutral third party, like a title company, that agrees to hold the title until the loan has been paid in full.

Most, if not all, lenders require a signed promissory note before issuing a loan. However, whether you have a mortgage or deed of trust will depend on what state you live in.

As of publishing, there are nine states that allow both a mortgage and a deed of trust. Most states only allow a deed of trust, although roughly 16 states allow only a mortgage. Nowadays, the terms “mortgage” and “deed of trust” are used pretty interchangeably.

A deed of trust and a mortgage are similar in that they both provide remedies for the lender through foreclosure — essentially, they give lenders the legal right to sell your home if you stop making payments on the loan.

With a mortgage, the foreclosure proceedings have to go through the courts, which can take a significant amount of time to complete. The legal fees can also be expensive for the lender. With a deed of trust, however, the trustee pursues a nonjudicial foreclosure, which is a foreclosure without first obtaining a court order.

Types of promissory notes

Promissory notes can be either secured or unsecured, depending on the loan.

• Secured: A secured promissory note is backed by collateral, which means the lender can take possession of and sell the item of value should you default on the loan. In the case of a home loan, the purchased property serves as collateral. This lessens the lender’s financial risk; if you default, it can collect proceeds from the sale of property and recoup some or all of its losses.
• Unsecured: Unsecured promissory notes are not backed by collateral, though the borrower is still legally obligated to repay the loan. While mortgage loans are secured, other types of loans, including personal loans, are typically unsecured. Often, interest rates for unsecured loans are higher because the lender considers itself at more risk.
• Master promissory note: A master promissory note is used for multiple loans by the same borrower. It’s still a written promise to repay debt, but it covers more than one particular loan. Master promissory notes are often seen with student loans because college students typically have to take a new loan at the start of each year.

Bottom line

A promissory note is a written promise to repay a loan. It lists important information about the terms of the loan, such as the name of the lender, the amount you are borrowing, the interest rate and the loan’s maturity date.

With a home loan, you will have to sign both a promissory note and a mortgage or deed of trust, which secures the loan with the property you are buying. Before you sign these documents, make sure you read them thoroughly; if you have questions, it may be helpful to speak with an attorney.