Promissory note

Key Takeaways

• A promissory note names a maker, who signs and owes the money, and a holder or payee, who is entitled to collect it.
• The promissory note is the debt itself, while the deed of trust or mortgage signed with it is only the security for that debt.
• A note that meets the negotiable instrument requirements can be transferred to a new holder, who can then enforce it on the original terms.
• A promissory note can serve as earnest money when the purchase and sale agreement allows it, but it is a promise to pay rather than funds already deposited.

What It Means

A promissory note is a signed written promise to pay money. The person who signs and owes is the maker. The person entitled to collect is the holder, sometimes called the payee. The note states the principal amount, the interest rate if there is one, when and how payment comes due, and what counts as Default. In a home purchase the buyer signs the note at closing and the lender becomes the holder.

Keep two documents apart. The note is the debt, a personal obligation to repay. The Deed Of Trust or mortgage signed alongside it is the security, the recorded document that lets the lender reach the property if the borrower stops paying. A lender sues on the note and forecloses on the security instrument.

Notes are not only for institutional lending. A seller can carry part of the purchase price on a note, a family member can lend on one, and a buyer can hand the seller a note instead of cash as Earnest Money when the purchase and sale agreement provides for it.

How It Works in Washington

In Washington, the rules that decide whether a note can be freely transferred come from the Uniform Commercial Code, adopted as RCW 62A. Under RCW 62A.3-104 a negotiable instrument is an unconditional promise to pay a fixed amount of money, payable to bearer or to order, payable on demand or at a definite time, and stating no other undertaking beyond the payment of money. Wording that makes the promise conditional, or that bolts on extra duties, can knock a note out of negotiable status. That matters because a holder of a negotiable note can enforce it even though the holder was not the original lender.

The note and the security instrument travel together but do different jobs. In Washington the security is almost always a deed of trust rather than a mortgage, and RCW 61.24.020 describes that as a deed conveying real property to a trustee in trust to secure the performance of an obligation. The obligation being secured is the note. Which security instrument goes with the note varies by state, so confirm the local rule rather than assuming the Washington pattern.

Example

Nathan agrees to buy a house in Vancouver, Washington for $460,000. The purchase and sale agreement calls for $6,000 in earnest money. His funds are in transit, so with the seller's agreement he delivers a promissory note for $6,000 payable within two business days of mutual acceptance. He wires the $6,000 on day two, which retires that note.

At closing Nathan puts $46,000 down, which is 10 percent, and signs a promissory note for $414,000 at 7 percent interest, payable in monthly installments over 30 years on an Amortization schedule. Nathan is the maker. The lender is the holder.

The first month's interest is $414,000 times 7 percent divided by 12, which is $2,415.00. His scheduled principal and interest payment is $2,754.35, so $339.35 of that first payment reduces principal and the balance falls to $413,660.65. Three years later the lender sells the loan. The new holder can enforce the same note on the same terms, and Nathan's payment does not change.

Common Mistakes and Exam Traps

• The note creates the personal obligation to repay and the mortgage or deed of trust only pledges the property, so a question about which document the borrower promises to pay on is asking about the note.
• The maker is the borrower who signs and owes, and the holder or payee is the party entitled to collect; candidates routinely swap these two roles.
• Signing a note by itself does not pledge any property, so without a recorded security instrument the lender is an unsecured creditor.
• A promissory note taken as earnest money is a promise to pay, not money sitting in a trust account, so the seller carries more risk than with a cash deposit.