Promissory Note — write the loan down.

What a promissory note is, and what it is not

A promissory note is a written promise to pay a fixed sum, on a stated date or schedule, to a named person. It is the shortest useful document in contract law: one page, two signatures, and a number. The reason to write one has nothing to do with formality. It is that the borrower and the lender will remember the arrangement differently a year later, and only the paper will still say what was agreed.

It is not a loan agreement, although the two are often confused. A loan agreement is the two-sided contract: it says what the lender will do, when the money is advanced, what conditions apply, and what the borrower must insure or maintain. A promissory note is the borrower's side alone: I promise to pay this amount, at this rate, on this schedule. For a mortgage, the note is the repayment promise and the mortgage is the charge on the property, which is why they are always signed together.

It is also not a receipt. A receipt proves money moved. A note proves money is owed. Family loans often need both, and the note is the one that matters if the relationship sours.

The eight terms a note has to get right

Courts read notes literally, because that is what a note is for. Each of these has to be present and unambiguous, or the document invites an argument that costs more than the loan.

1. Principal. A figure in words and digits. If the numbers disagree, the words usually control, which is exactly the fight the writing is meant to prevent. This tool writes both from one field so they cannot drift.
2. Interest rate, and how it accrues. An annual percentage rate is not enough on its own; say whether it is simple interest on the unpaid balance, compounded monthly, or discounted up front. A note that charges 5 per cent but does not say on what balance will be read against the lender.
3. Payment schedule. An amount, a frequency and a date. "When he can afford it" is not a schedule, and a note without one is payable on demand, which is a much blunter instrument than most families intend.
4. Maturity. The date the whole balance falls due, whether or not the instalments were made. Without it the note has no end date and the limitation period is harder to pin down.
5. Place and manner of payment. Where the money goes, and what counts as paid. Payment by transfer is not complete until it clears.
6. Prepayment. Whether the borrower can pay early, and whether there is a penalty. In consumer lending, a prepayment penalty is restricted in many states; between family members it is nearly always waived, and saying so removes a source of friction.
7. Default and acceleration. What counts as a default, how many days of grace, and what happens then. Acceleration is the clause that turns one missed payment into a claim for the whole balance.
8. Governing law and signatures. Which state's law applies, and a signature from each side, dated.

The arithmetic, worked out in the open

The default example on this page is an 8,000 dollar loan at 5 per cent a year, repaid over 36 months in equal instalments. The monthly payment is not 8,000 divided by 36 with interest sprinkled on top; it comes from the annuity formula, P × i ÷ (1 − (1 + i)⁻ⁿ), where i is the monthly rate and n the number of payments.

Five per cent a year is 0.416667 per cent a month, or 0.0041667. Plugging in: 8,000 × 0.0041667 = 33.33, and 1 minus (1.0041667)⁻³⁶ is 0.13904, so the payment is 33.33 ÷ 0.13904 = 239.77 a month. Over 36 payments that is 8,631.60, which makes the interest 631.60. Because the instalment is rounded to the cent, the final payment is 239.65 so the balance lands exactly on zero, and the schedule this tool prints shows that adjustment rather than hiding it.

At 0 per cent the same loan is 222.22 a month. At 8 per cent it is 250.69, and the interest over the term is 1,024.89. That gap, about 11 dollars a month for three years, is the whole cost of the rate, and it is worth showing the borrower before they sign, because a rate that looks small in a sentence looks different as a line on a schedule.

A worked example: the house deposit loan

Marta lends her son Daniel 8,000 dollars towards the closing costs on a house in Sacramento. The money leaves her savings on 1 March. Both expect it to come back, neither wants to talk about it every Thanksgiving, and the son-in-law's parents have offered the same amount with no paperwork at all, which is exactly why Marta wants the note.

She fills in the lender and borrower names, the 8,000 principal, 5 per cent, a 36-month term and a payment date of the first of the month. The governing law stays on California, the purpose line reads "closing costs on a house purchase", the late fee is 25 dollars after a 15-day grace period, and she ticks notarised because her credit union does it free for members.

The note comes out at just over a page: the promise, the principal in words and figures, the interest clause charging the annual rate on the unpaid balance each month, 36 instalments of 239.77 beginning 1 April, the right to prepay without penalty, default at more than 30 days late with the whole balance accelerated, a clause saying this is a loan and not a gift, and the governing law. Below the signature blocks it carries a short acknowledgement for the notary.

Two details make the difference later. The purpose line matters because a note that funds a house purchase can, with a separate recorded instrument, become a claim on that house; without the line, the note is unsecured and only a promise. And the "loan, not a gift" sentence matters for tax: an undocumented transfer between parent and child is the shape of a gift, and the lender is the one who has to prove otherwise if the IRS or a state agency asks.

Where promissory notes go wrong

• A blank or rounded principal. Writing 8,000 when 8,000 was not the amount transferred leaves the borrower able to argue the note does not describe the loan. The principal should be the amount actually advanced, net of any fees.
• Interest stated as a monthly figure. "2 per cent interest" on a note is read as 2 per cent a year unless it says otherwise. A note that meant 2 per cent a month is a 24 per cent loan, and above the state usury limit in several states.
• No acceleration clause. Without it, a lender whose borrower stops at payment 12 can sue for payment 12 only, then payment 13 next month, and so on. The clause exists so one default reaches the whole balance.
• A signature from the wrong person. If the borrower is married and the money went into a joint account, a note signed by one spouse may still bind only that spouse. Both should sign, or the note should say who is liable.
• No record of the transfer. The note says money was lent; the bank statement says it arrived. Keep both. A note with no corresponding transfer is a note with a consideration problem.
• Interest quoted above the state cap. Usury limits for private loans vary widely, and a rate that is fine in one state is void or reduced in another. The flag under the calculator warns when the figure looks high for the state selected.
• Assuming the note secures the car. It does not. Security needs a separate agreement and a filed UCC-1, or a recorded lien on a title.

Before you both sign

Read the note out loud to the borrower, including the payment amount and the final date. Most disputes about family loans are not about the law, they are about one side having assumed a different schedule. Then sign two copies, one each, and keep the transfer record with the lender's copy. If the loan is above the annual gift exclusion and carries no interest, ask an accountant about imputed interest before the first payment, not after the first tax return.

Questions