What is a Promissory Note?
A promissory note refers to a financial instrument that includes a written promise from the issuer to pay a second party – the payee – a specific sum of money, either on a specific future date or whenever the payee demands payment (depending on the terms of the note). The promissory note should include all terms that relate to the indebtedness, including when and where the note was issued, the principal amount the issuer owes, what the interest rate on the note is, and when the note reaches maturity (becomes due).
Promissory notes are debt instruments. They can be issued by financial institutions. However, they can also be issued by small companies or individuals. Promissory notes enable a person or a business to obtain financing without going through a bank. The issuer of the note simply must be willing to carry it until maturity and be willing and able to provide the funds specified in the agreed-upon terms laid out in the note.
Promissory Notes as Corporate Credit
In the business world, promissory notes are often used to provide short-term credit. If, for example, a small company has sold goods or services, but has yet to receive full compensation for them, cash flow dwindles and it might have difficulty managing its debts. The company can ask its creditors to accept a promissory note, with the condition that they will pay the total amount they owe on the note in the future once their accounts receivables are collected. They can also ask a financial institution to accept a promissory note, essentially taking out a temporary loan and paying it back once they have the funds to do so.
Promissory notes are also a potentially good source of short-term credit for companies that have already exhausted more traditional options like bond issues and corporate loans. This usually means, however, that the issuing company is more likely to default. It also means that the interest rate on the note will offer a higher return.
Corporate promissory notes usually have to be registered both in the state they’re issued in, as well as with the Securities and Exchange Commission (SEC). Regulators then examine the note and the issuing company to determine if the company can realistically fulfill the promises outlined in the note.
Promissory Notes for Students
For many Americans, the introduction to promissory notes comes with the process of getting a student loan for secondary education. Many lenders – specifically private lenders – make students sign promissory notes for each loan they take out to pay for schooling.
Some schools let students borrowing federal loans sign a single, master promissory note, enabling them to receive multiple other federal loans as long as they remain eligible under the terms of the master note. The note outlines the conditions and terms of repayment, which usually include the original loan amount, plus interest, and, if the loans are federal, the student must pay back the total amount to the U.S. Department of Education, which is specified in the master promissory note the student initially signed.
We hope you enjoyed our overview of promissory notes. For more information on credit and business financing, CFI provides a number of additional free resources that you can check out: