A promissory note is a signed document in which one person, the maker, promises to pay a specific sum of money to another person, the payee, either on a set date or whenever the payee demands it. It goes further than a casual IOU, which only acknowledges that a debt exists. A promissory note spells out the repayment terms: how much, when, and at what interest rate. Drafted correctly, it also qualifies as a negotiable instrument under the Uniform Commercial Code, meaning the payee can sell or transfer the right to collect to a third party.
Mortgages, car loans, student loans, private loans between family members, and early-stage startup investments all typically involve a promissory note of some kind. The document is short, but the details in it decide who owes what, when, and what happens when someone doesn’t pay.
What a Promissory Note Must Contain
The UCC’s list of formal requirements is short. Under Section 3-104, the note must contain an unconditional promise to pay a fixed amount of money, be payable on demand or at a definite time, be payable “to order” or “to bearer,” and carry the maker’s signature. The note cannot require the maker to do anything beyond paying money, with narrow exceptions for pledging collateral or waiving certain legal protections.1Legal Information Institute. Uniform Commercial Code 3-104 – Negotiable Instrument
That is the floor. A note meeting only those bare requirements would be technically negotiable but practically incomplete. A well-drafted promissory note also includes:
- Full names and addresses of both maker and payee.
- The principal amount as an exact dollar figure.
- The interest rate and how it is calculated (fixed, variable, or explicitly zero).
- The payment schedule: amount of each payment, frequency, and first payment date.
- The maturity date when the final payment is due.
- Default provisions defining what counts as a breach and what happens next.
- A governing law clause specifying which state’s law controls.
Without clear terms on the payment schedule and default triggers, enforcing the note in court becomes far more expensive and uncertain, even if the note technically satisfies the UCC. A note that is too vague on material terms can also fail the general contract law requirement that agreements be definite enough for a court to determine the parties’ obligations.
Only the maker’s signature is strictly required. The payee does not need to sign for the note to be valid. Some states require notarization for notes secured by real estate. Whether or not yours does, notarizing the maker’s signature adds protection against future forgery claims and usually costs under $25.
Common Types You’ll Encounter
Installment Notes vs. Demand Notes
An installment note is what most people picture when they think of a loan: regular payments of principal and interest spread over a set period until the balance reaches zero. Mortgages, car loans, and student loans all use installment notes. Both sides know the exact monthly obligation and when the debt will be fully retired.
A demand note has no fixed repayment schedule. The payee can call the entire balance due at any time, typically after giving reasonable notice.2Legal Information Institute. Demand Note Demand notes appear most often in short-term business financing and loans between family members or business partners. The maker can often repay on a comfortable schedule as long as the lender stays satisfied, but there is no guaranteed timeline.
Secured vs. Unsecured Notes
A secured note ties the maker’s repayment promise to a specific asset, such as real estate, a vehicle, or business equipment. If the maker stops paying, the payee can seize and sell that collateral to recover what is owed. Because the payee has that fallback, secured notes carry lower interest rates and are easier to obtain, especially for large loans.
An unsecured note relies entirely on the maker’s promise and creditworthiness. There is no collateral to claim if things go wrong, so unsecured notes carry higher rates. Personal loans between individuals and most credit card debt are unsecured.
Convertible Notes
Convertible notes occupy a niche in startup financing. The investor lends money to a company, and instead of collecting repayment in cash, the loan converts into ownership equity when a specific event occurs. The most common trigger is a future fundraising round that meets a minimum size. Some convertible notes also convert at maturity or on a company sale. The structure lets early investors and founders skip the difficult exercise of valuing a brand-new company while still putting capital to work.
Interest Rate Limits
Every state caps the interest rate a private lender can charge, and the caps vary widely. Maximum allowable rates for personal loans range from roughly 5% to 45% depending on the jurisdiction, the type of lender, and whether the lender holds a state license. Banks and credit unions are often exempt from state usury limits under federal preemption. A private individual lending to a friend or business partner is not. Charging interest above your state’s cap can void the interest entirely, make the note unenforceable, or trigger penalties. Before setting a rate on a private promissory note, check your state’s usury statute.
Charging too little interest creates the opposite problem, especially in family loans. Under Internal Revenue Code Section 7872, when you issue a loan below the IRS’s Applicable Federal Rate (AFR), the IRS treats the difference as imputed interest. The lender owes income tax on that phantom interest even though no cash changed hands. For January 2026, the AFR ranges from 3.63% annually on short-term loans (three years or less) to 4.63% annually on long-term loans (more than nine years).3Internal Revenue Service. Revenue Ruling 2026-2 – Applicable Federal Rates The IRS publishes new rates monthly, so check the rate in effect when the note is issued.
Consider a parent who lends a child $200,000 at 0% interest on a ten-year note. The IRS will impute interest at the long-term AFR each year and treat it as taxable income to the parent. The forgone interest may also be treated as a gift from lender to borrower. The cleanest way to avoid both problems is to charge at least the AFR and document the loan with a proper promissory note that includes a repayment schedule. Without documentation, the IRS can reclassify the entire loan as a gift. For 2026, the annual gift tax exclusion is $19,000 per recipient, so any recharacterized amount above that begins eating into the lifetime exemption.
Rights on Both Sides
The maker’s core obligation is straightforward: make every payment in full and on time. Missing a payment triggers whatever default provisions the note contains, which can escalate quickly from late fees to full acceleration of the balance.
The payee’s corresponding right is to receive those payments as scheduled. Most notes let the payee charge late fees after a defined grace period, but only if the fee structure is written into the original document. A payee trying to impose late fees that were never disclosed in the note will have trouble collecting them.
Prepayment is worth checking before signing. Many consumer loan agreements permit early payoff without penalty, and some states prohibit prepayment penalties for certain loan types altogether.4Consumer Financial Protection Bureau. Can I Prepay My Loan at Any Time Without Penalty Commercial notes frequently include a prepayment penalty to compensate the payee for the interest income lost when the loan ends early.5Legal Information Institute. Prepayment Penalty If your note is silent on prepayment, the default rule in most jurisdictions allows early payoff without penalty, but confirm before writing a large check.
What Happens When Payments Stop
A default happens when the maker violates a term of the note. Missing a payment is the obvious trigger, but a note can define default more broadly to include things like failing to maintain insurance on collateral or filing for bankruptcy. The definition determines how quickly the payee’s enforcement rights activate.
Acceleration Clauses
The most consequential provision in most promissory notes is the acceleration clause. When triggered, it makes the entire remaining balance due immediately rather than allowing the maker to continue with scheduled payments. A maker who is behind $500 on a $100,000 note can suddenly owe the full $100,000. Not all acceleration clauses fire automatically. In many notes, the payee has the option to invoke the clause, and if the maker cures the default before the payee exercises that option, the right to accelerate may be lost. That cure window is worth negotiating into any note you sign as a borrower.
Enforcing a Secured Note
When a secured note goes into default, the payee can seize and sell the pledged collateral. For real estate, this means foreclosure. For personal property such as equipment or vehicles, the process is governed by UCC Article 9, which gives the secured party the right to repossess, sell, or retain the collateral after default. Sale proceeds go toward the outstanding debt, and if the sale doesn’t cover the full balance, the payee can pursue the maker for the remaining deficiency in most states.
Enforcing an Unsecured Note
Without collateral, the payee’s only enforcement path is a civil lawsuit. A judgment in the payee’s favor opens the door to collection tools like wage garnishment and bank account levies.6Consumer Financial Protection Bureau. Can a Debt Collector Take or Garnish My Wages or Benefits Federal law limits how much of a paycheck a creditor can garnish, and state exemption laws may protect additional wages or property from collection.7U.S. Department of Labor. Garnishment Many notes also make the defaulting maker responsible for the payee’s attorney fees and court costs, which adds meaningfully to the total bill.
Deadline to Sue
Payees cannot wait forever to enforce a promissory note. Under UCC Section 3-118, the standard deadline to sue on a note with a fixed maturity date is six years from the due date. If the balance was accelerated, the clock starts from the accelerated due date. For demand notes where the payee actually made a demand, the six-year window runs from the date of demand. If no demand was ever made and no payments of principal or interest have occurred for ten continuous years, the claim is barred entirely.8Legal Information Institute. Uniform Commercial Code 3-118 – Statute of Limitations These are default UCC rules; some states have adopted shorter or longer periods.
Tax Consequences to Know About
Two tax traps catch people off guard.
The first hits borrowers. If a payee forgives or settles a debt for less than the full amount owed, the canceled portion is generally taxable income to the maker. Creditors who cancel $600 or more in debt must file Form 1099-C reporting the forgiven amount, and the maker must include that amount on their return as other income.9Internal Revenue Service. About Form 1099-C, Cancellation of Debt Exceptions exist for borrowers who are insolvent or in bankruptcy. Outside those situations, a $50,000 debt settlement can produce a surprise tax bill of several thousand dollars.10Internal Revenue Service. Form 1099-C – Cancellation of Debt
The second hits lenders, particularly in family transactions. Lending below the AFR triggers imputed interest under IRC Section 7872, and the IRS will treat the lender as having earned that interest regardless of what was actually collected. If a family loan lacks a written promissory note, a reasonable interest rate, and a documented history of actual repayments, the IRS can reclassify the entire transaction as a gift. For amounts above the $19,000 annual gift tax exclusion per recipient, the reclassification starts reducing your lifetime estate and gift tax exemption. The defense is a signed promissory note, an interest rate at or above the AFR, a repayment schedule the borrower actually follows, and records showing that payments were made on time.