- A promissory note is a written legal promise to repay a loan.
- In real estate, promissory notes are commonly used when financing a home, borrowing against a home, refinancing an existing home loan, or taking a construction loan.
- Promissory notes are different from mortgages. The note outlines the legal promise to pay while the mortgage creates a legal claim against the property being used as collateral for the loan.
Buying a home or investment property requires a fair amount of paperwork. Reviewing and signing these documents may not be the most exciting part of buying a property. Still, it is necessary to make sure all parties clearly understand the terms of the arrangement.
A promissory note is a critical part of real estate transactions that involve financing. In fact, this legal document is used in multiple ways in real estate. However, it’s often misunderstood.
In this article, we’ll explain what promissory notes are, how they’re used in real estate, and why they’re important to homebuyers, homeowners, and real estate investors across the country.
What Is a Promissory Note in Real Estate?
In real estate, a promissory note is a legal document that outlines a borrower’s promise to repay their home mortgage loan. The purpose of the promissory note is to serve as written consent of the borrower’s agreement to the terms of the loan, including the principal amount, interest rate, and timeframe.[1]
When Is a Promissory Note Used in Real Estate?
A promissory note is used in multiple situations in real estate:
- When a buyer finances the purchase of a property with a mortgage loan.
- When a homeowner borrows against their home equity with a home equity loan or home equity line of credit (HELOC).
- When a homeowner refinances their mortgage to change the terms of the loan.
- In seller financing, when a seller provides the funding for a homebuyer.
- When a property owner accepts a construction loan to build or renovate a property.
What Information Is Listed on a Promissory Note in Real Estate?
A promissory note includes the following:[1]
- The loan amount. This is the total amount borrowed from the lender.
- The interest rate. For a fixed-rate mortgage, the interest rate in the note is the interest rate for the entire loan term. If you have chosen an adjustable-rate mortgage (ARM), the rate listed on the note is the initial rate. A promissory note for an ARM also includes a section discussing how the rate automatically adjusts to changing market conditions within any pre-determined limitations after the initial period.
- When and how payments are to be made. This includes payment due dates as well as instructions for where to send payments.
How Is a Promissory Note Used in Real Estate?
A promissory note is typically used as follows:[2]
- The borrower signs the promissory note, creating a legal promise to repay the lender as agreed.
- The lender holds the original note, while the borrower retains a copy.
- The note gives the lender legal permission to collect on the debt.
- When the loan is paid in full, it is marked as such and returned to the borrower.
Importantly, only the individuals (or entities) who sign the promissory note are responsible for repaying the lender.
Promissory Note vs. Mortgage
Promissory notes are often confused with mortgages. Many homebuyers mistakenly believe that the mortgage is the legal document that requires repayment of the home loan. The purpose of the mortgage is actually to place a lien (a legal claim) on the property. This lien is what grants lenders the right to foreclose on the property if the borrower fails to repay the debt as they agreed to in the promissory note.[2]
Key Differences Between a Promissory Note and a Mortgage
A promissory note is used to document the borrower’s legal obligation to repay the loan. In contrast, a mortgage is used to document the lender’s claim against the property until the loan is repaid in full plus interest.
The promissory note outlines the terms of the loan, while the mortgage explains the consequences for the borrower if they default on the loan.
How Promissory Notes and Mortgages Work Together in Property Financing
Together, the promissory note and mortgage create a legally binding arrangement between a lender and a borrower to ensure the lender is repaid under the terms both parties have agreed to.
Can You Have a Mortgage Without a Promissory Note?
Mortgages are typically accompanied by a promissory note. However, there are rare cases in which someone might have to sign the mortgage but not the note.[2]
Imagine a homebuyer with a lower credit score who does not qualify for a home loan at a favorable interest rate. Now imagine that this person’s spouse has excellent credit and easily qualifies for the loan. In this case, the lender may agree to issue the loan to the spouse, excluding the unqualified buyer from the promissory note. However, if both spouses are named on the property’s deed (the legal instrument that transfers ownership), the lender may require the unqualified spouse to sign the mortgage as well. This would mean the spouse who signed the note bears the legal responsibility for repaying the loan, but the lender has consent from both spouses to initiate foreclosure if the loan goes unpaid.
Can You Have a Promissory Note Without a Mortgage?
In real estate, a promissory note typically links to a mortgage. However, outside of real estate, promissory notes often exist without mortgages. For example, you might have a promissory note to repay a student loan, which would be unrelated to any mortgage.
Secured vs. Unsecured Promissory Notes
A secured promissory note is backed by collateral, while an unsecured promissory note is not.
In real estate, promissory notes are typically secured, using the property as collateral for the loan, as detailed in the mortgage.
Unsecured promissory notes are more common in different types of lending, including student loans, personal loans, and medical loans.
Promissory Note FAQs
What Happens if I Default on a Promissory Note?
If a borrower defaults on a promissory note, the lender can take legal action to recover the debt. In real estate, this usually involves initiating foreclosure on the property tied to the promissory note and mortgage.
Are Promissory Notes and Loan Agreements the Same Thing?
While similar, a loan agreement has a broader scope than a promissory note. The loan agreement includes information relating to conditions, representations, and warranties, while a promissory note focuses on repayment terms.
Can a Promissory Note Be Transferred to Another Lender?
Lenders can sell or transfer promissory notes to other lenders through a process called assignment. When this happens, the borrower must make payments to the new lender as specified in the transfer notice, which is provided to the borrower by both the original lender and the new lender.
Can the Terms of a Promissory Note Be Modified?
The terms of a promissory note can be modified if both the borrower and lender agree. This may be done during a loan modification, in which the interest rate, payment schedule, or loan balance is adjusted.
What Happens To a Promissory Note if a Home Loan Is Refinanced?
In a mortgage refinance, the original promissory note tied to the existing loan is satisfied and replaced with a new note that reflects the terms of the refinanced loan.
The Bottom Line
Real estate transactions are among the most consequential financial decisions most people will make. Multiple legal documents are used to make sure all parties understand their rights and responsibilities in the transaction.
The promissory note is important for anyone buying property or otherwise using property as collateral for a loan because it documents their commitment to repay the loan.
If you are buying a home, investing in real estate, or borrowing against home equity, understanding the legal documents you’ll be signing minimizes your risk and sets you up for a successful transaction.
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