How a promissory note works, from both sides

What is a promissory note?

A promissory note is a signed, written promise to repay money on stated terms. The person who signs and pays is the borrower (in a home sale, the buyer). The person who is owed the money is the holder of the note: a lender, or a seller who lets the buyer pay over time.

Every car loan, mortgage and student loan has a note underneath it. So does every seller-financed sale, where the seller takes a down payment and lets the buyer pay the rest in monthly installments. The note is what turns “I’ll pay you back” into numbers anyone can check: how much, at what rate, how often and for how long.

That makes a note the simplest way to be on the collecting side of interest. Most people pay interest every month; the holder of a note receives it. This guide follows one note from both sides, using one example throughout: $6,000 at 15% for 36 months, the balance left after a $7,500 home is sold with $1,500 down.

Promissory note calculator

Enter the amount, the rate and the number of months the payment is figured on. Add a balloon month if the balance comes due early. It shows the payment, the interest the holder collects and a year-by-year schedule.

With the defaults, the payment is $207.99 a month. Over 36 payments the buyer pays $7,487.71, so the interest comes to about $1,488.

What goes in a promissory note?

At minimum: the amount, the rate, the payment and the dates. A good note also says exactly what happens when something goes wrong. These are the parts to look for, whichever side you are on.

• Amount (principal). What is owed on day one. In a sale, that is the price minus the down payment.
• Interest rate. The yearly rate, and whether it is fixed or can change. Notes are quoted as a note rate, which is the monthly rate × 12.
• Term and payment. How many payments, how much each, and the number of months the payment is figured on (the amortization). If those two differ, the note has a balloon.
• Due dates and where to pay. The first due date, the day of the month and where payments go.
• Late fees and grace period. How many days late a payment can be before a fee, and how big the fee is.
• Default and acceleration. What counts as default (a missed payment, unpaid taxes, no insurance), what notice is given, and whether the holder can call the whole balance due at once. That last right is called acceleration.
• Prepayment. Whether the borrower can pay early, and whether there is any charge for it.
• Security. Which document (a mortgage, a deed of trust or a lien on a title) pledges the property, so the note is more than an unsecured promise.
• Signatures and dates, with a signed copy for each side.

Lending rules, the most interest a note may charge (the usury limit), late-fee limits and licensing rules differ from state to state. Check your state before you write or sign one.

How is the payment on a promissory note calculated?

The payment is the one fixed monthly amount that covers each month’s interest and brings the balance to exactly zero on the last payment. One formula gives it.

Each month, interest is the balance × the monthly rate. The payment covers that interest first, and the rest comes off the balance.

Year by year, the same note looks like this:

More than half the interest arrives in the first year. That matters to the holder: a note that is paid off early has still delivered most of its interest.

What the lender collects and the buyer pays

The same $207.99 is income to one side and a cost to the other. Here is the note from each.

The holder’s side

Lend $6,000 in cash, collect 36 payments, and you get $7,487.71 back: about $1,488 of profit on $6,000 of cash at risk. Your cash is back in full in month 29; the last payments after that are the profit. The yield is the note rate, 15%, which is 1.25% a month. Compounded over a year (1.0125¹² − 1) that is about 16.08%, as long as every payment arrives on time.

In a seller-financed sale the picture changes, because the seller never handed over $6,000 in cash. The seller handed over a home, and only the cash that went into the home is at risk.

The buyer’s side

The buyer pays $1,500 down plus 36 payments of $207.99: about $8,988 in all for a $7,500 home. The rate is the biggest thing the buyer can negotiate. The same $6,000 over 36 months costs:

A fair note is one both sides can read the same way: the holder knows what it earns and the buyer knows what it costs, before anyone signs.

How does a balloon note work?

A balloon note figures the payment over a long schedule but makes the whole remaining balance due sooner. The payments are smaller, and the last one is large.

What does a promissory note not do on its own?

A note is a promise to pay. It does not pledge the property and it does not transfer ownership. Other documents do those jobs.

• Security. For a house on its own land, the property is usually pledged with a mortgage or a deed of trust, depending on the state. That is the document that lets the holder take the property back after a default. Without one, the holder of an unpaid note is just someone who is owed money.
• Title. Who owns the property is shown by the deed for real estate, or by the certificate of title for a mobile home titled as personal property. Some sales transfer title at once; some arrangements keep it with the seller until the last payment. The note itself says nothing about who owns what.
• Recording. A security document protects its holder best when it is recorded, or noted on the title, the way your state requires, so later buyers and lenders can see it.

How a mobile home is titled (as personal property or as part of the land), how a lien is noted and how a home is taken back all depend on the state. Check your state’s titling agency and rules.

Seller-financed notes and the federal rules

Regulation Z, which carries out the federal Truth in Lending Act, can reach a seller-financed note on a home. Here are the parts that matter most, in plain terms, from the rule text.

• A mobile home counts as a dwelling. The rule defines a dwelling as a residential structure with one to four units, whether or not it is attached to real property, and names mobile homes and trailers used as a residence.
• Whether you are a “creditor” depends on a count. Someone regularly extends credit if they did so more than 25 times, or more than 5 times for loans secured by a dwelling, in the preceding calendar year, or originated more than one high-cost mortgage in any 12-month period. Truth in Lending disclosures and the ability-to-repay rule, which covers consumer credit secured by a dwelling, turn on that status.
• Three or fewer properties in 12 months: a seller is not a loan originator if each property is theirs and secures the financing, they did not build a home on it in the ordinary course of business, the financing is fully amortizing, they decide in good faith the buyer can reasonably repay, and the rate is fixed or adjusts only after five or more years with reasonable caps.
• One property in 12 months: a natural person, estate or trust selling one property it owns is not a loan originator if it did not build a home on it in the ordinary course of business, the payments do not cause negative amortization, and the rate is fixed or adjusts only after five or more years with reasonable caps.

These exclusions only take a seller out of the loan originator definition. They do not make a seller exempt from every rule, and state rules (usury limits, licensing, dealer and titling rules, repossession) sit on top. Check your state.

Promissory note math in Excel and Google Sheets

The same spreadsheet functions work for any note. A minus sign in the answer only means money going out.

• Payment: =PMT(15%/12, 36, 6000) returns −207.99. Figured over 60 months, =PMT(15%/12, 60, 6000) returns −142.74.
• Interest in one month: =IPMT(15%/12, 1, 36, 6000) returns −75.00, the first month’s interest.
• Interest in year one: =CUMIPMT(15%/12, 36, 6000, 1, 12, 0) returns −785.58, matching the table above.
• Balloon: =FV(8%/12, 60, 366.88, −50000) returns about 47,535, the balance left on the $50,000 note after five years.

Always divide the yearly rate by 12 and count periods in months. A yearly rate with a monthly count of periods gives nonsense.

What can go wrong with a note?

The note rate is only what the holder earns if the payments arrive. These are the usual ways they do not.

• Default. The borrower stops paying. If the holder lent $6,000 in cash and the payments stop after 8, the holder has collected $1,663.92 and is out about $4,336 until the property is recovered and sold, with costs along the way.
• Early payoff. The borrower refinances or sells and pays the balance. The holder gets the money back sooner and stops collecting interest. That is neutral at face value and a bonus for someone who bought the note at a discount.
• Taxes, insurance and condition. If property taxes go unpaid, or the home is uninsured or neglected, the security behind the note is worth less.
• Servicing. Someone has to record each payment, send statements and keep a clean history. A note with a messy payment history is worth less to a buyer later.
• A seller’s own mortgage. If the seller still owes a mortgage on the property, that loan may let its lender call it due when the property is sold. Check the seller’s loan documents before selling on terms.

Before you lend to anyone, make sure you are not paying more interest than you would collect. A card balance at 24% costs far more than most notes pay, and the leak check finds that kind of drain first.

Further reading: creating and improving notes is covered at book length in Lonnie Scruggs’s Taking the Mystery Out of Money.