What Are Promissory Notes and How Do They Work?

A promissory note is a written, signed promise from one party (the borrower, or “maker”) to pay a specific sum of money to another party (the lender, or “payee”) either on a set schedule or on demand. Promissory notes turn up in casual loans between relatives and in multimillion-dollar real estate deals alike, and in each case they create a legally enforceable debt. The core rules come from Article 3 of the Uniform Commercial Code, which every state has adopted in some form.¹

What a Promissory Note Has to Say

A promissory note doesn’t have to be long. It does have to name the borrower and the lender by their full legal names, state a specific dollar amount of principal, and contain an unconditional promise to pay that amount.¹ Beyond those bones, most notes also spell out:

The interest rate, usually as an annual percentage. Some family arrangements charge nothing, though the IRS may still impute interest if the rate is too low.
The repayment schedule — regular installments or a single lump sum at the end of the term.
The maturity date, meaning the final deadline for the balance. A note that fails to state any payment date is treated as payable on demand, which lets the lender call it due whenever they want.²
Late fees, as a flat charge or a percentage of the missed payment.
An acceleration clause, which lets the lender declare the whole remaining balance due immediately after a missed payment or other default.
Prepayment terms — whether the borrower can pay early, and whether doing so triggers a fee. Federal law restricts prepayment penalties on most residential mortgages.

Types You’ll Encounter

Personal notes usually cover loans between friends, family, or acquaintances, and they’re often unsecured, which means no asset backs the promise. Commercial notes cover businesses borrowing from banks or private lenders, and they tend to include stricter terms and require business assets as collateral.

Real estate notes come paired with a mortgage or deed of trust. The note is your promise to repay; the mortgage gives the lender a security interest in the property so it can foreclose if you stop paying. These are typically the longest-running promissory notes, often 15 to 30 years.

Demand notes have no fixed maturity date. The lender can request full payment at any time, and under the UCC a note that doesn’t state a payment date automatically qualifies as payable on demand.²

Investment notes — notes companies issue to investors in exchange for a fixed return — raise a separate question the ordinary borrower doesn’t face: they may qualify as “securities” under federal and state law, which would subject the issuer to SEC registration requirements and give investors anti-fraud protections. The Supreme Court set out the test in Reves v. Ernst & Young, presuming that a note is a security unless it closely resembles categories that aren’t, such as short-term notes secured by a home or small business.³

What Makes One Enforceable

Three things turn signed paper into a real legal obligation.

The first is a signature. Nobody is liable on a promissory note unless they signed it, or an authorized agent signed for them.⁴ Handwritten, typed, stamped, or electronic all work as long as the signer intended to authenticate the document.

The second is consideration. Something of value has to change hands — typically money going to the borrower in exchange for the promise to repay. Without that exchange, a court can treat the note as an unenforceable gift promise.

The third is delivery. The signed note has to reach the lender, physically or digitally, before the obligation activates.

Witnesses and notarization are not required under the UCC. A note signed by the borrower and delivered to the lender is valid without either. Notarization can still make authenticity easier to prove in court, and some jurisdictions require it for certain secured loans.

How Promissory Notes Get Transferred

One of the more surprising features of a promissory note is that it can be sold or handed off to someone else, much like endorsing a check over to a third party. To transfer cleanly, the note has to qualify as a “negotiable instrument” under Article 3: an unconditional promise to pay a fixed amount, payable to a named person’s order or to whoever holds the document (“bearer”), with no obligations attached beyond paying money.¹ The lender endorses the back and passes it on.

The UCC recognizes three categories of people who can enforce a note: the current holder, someone in possession who acquired the holder’s rights, and — for a lost or destroyed note — someone who can prove both the note’s terms and their right to enforce it.⁵

This is why the person collecting your mortgage payment often isn’t the bank that originally lent you the money. Selling notes on the secondary market frees up cash for the original lender to make new loans. Your obligation doesn’t change with the transfer; only the payee changes.

Holder in Due Course

A buyer who takes the note in good faith, pays value for it, and has no reason to know about problems with it earns a special status: “holder in due course.”⁶ Most defenses the borrower could have raised against the original lender are cut off against this new holder. If you signed the note because the original lender promised to deliver goods and never did, that broken promise likely won’t work as a defense against someone who bought the note later without knowing about the dispute.

A short list of defenses survives even against a holder in due course: fraud that tricked the borrower into signing without understanding what they were signing, legal incapacity such as being a minor, duress, illegality that voids the obligation under other law, and discharge in bankruptcy.

What Happens If the Borrower Doesn’t Pay

The lender’s options depend on what the note says and whether the loan is secured.

Charge whatever late fee the note specifies.
Accelerate the balance, if the note allows it, and demand the full remaining amount at once instead of the missed installment.
Sue for a judgment. A signed promissory note is strong evidence of the debt, so these cases often move quickly. A judgment can then be used to garnish wages or place liens on the borrower’s property.
Foreclose or repossess, if collateral secures the note, using the process laid out in the security agreement.

How Long the Lender Has to Sue

Under the UCC’s default rule, a lender has six years after the due date stated in the note to file suit. If the lender accelerated the balance after a default, the six years run from the accelerated due date.⁷

Demand notes run on a different clock. If the lender makes a demand, the six-year period starts from that demand. If no demand is ever made and neither principal nor interest is paid for a continuous ten years, the note becomes unenforceable.⁷ Individual states may set shorter or longer periods, roughly three to ten years across the country for written debt obligations.

How the Obligation Ends

The cleanest ending is full payment. Once the borrower pays the entire principal and any remaining interest, the obligation is discharged.⁸ Other paths include the lender agreeing to cancel the debt, a bankruptcy court discharging it, or the parties settling through accord and satisfaction — for example, the borrower sends a partial payment with a clear written statement that it’s offered as full settlement, and the lender cashes it.⁹

There’s a catch. If the note was transferred to a holder in due course who didn’t know about the discharge, the borrower’s obligation may not count as discharged against that new holder.⁸ Always get written confirmation when a note is paid off or forgiven, and keep it.

Tax and Interest-Rate Rules to Know

Interest Is Taxable Income

If you lend money under a promissory note and collect interest, that interest is taxable. Reporting requirements kick in when total interest paid to a single borrower reaches $10 or more in a year.¹⁰ Interest on a note issued by an individual (rather than a business or financial institution) is generally excluded from Form 1099-INT reporting, but the lender still owes tax on it.

Below-Market Loans and Imputed Interest

Lending to a friend or family member at little or no interest can create tax exposure you didn’t expect. Under federal tax law, any loan charging less than the Applicable Federal Rate (AFR) counts as a “below-market loan.”¹¹ The IRS publishes AFRs monthly for short-term (three years or less), mid-term (over three years but not more than nine), and long-term (over nine years) loans.¹²

When a loan sits below the AFR, the IRS treats the gap between what the borrower actually pays and what the AFR would have produced as “forgone interest.” For gift loans between family, the forgone interest is treated as though the lender gave that amount to the borrower and the borrower paid it back as interest, which creates potential income tax and gift tax consequences for the lender.¹¹

Two exceptions ease the sting on smaller loans. If total loans between you and the borrower stay at or below $10,000, the imputed interest rules don’t apply.¹¹ For gift loans at or below $100,000, the imputed interest for any year is capped at the borrower’s net investment income for that year, and if that investment income is $1,000 or less, it’s treated as zero.

Usury Caps

Every state sets a maximum interest rate for private loans. Caps vary widely, from roughly 5% to 45%, depending on the state, the loan type, and the amount borrowed. Many states tie their limits to a benchmark like the Federal Reserve discount rate, so the cap moves over time.

Charging over the legal rate has real consequences. A national bank that knowingly charges more than the permitted rate forfeits all interest on the loan, not just the excess. A borrower who already paid the illegal interest can sue to recover twice the amount paid, provided they file within two years of the illegal charge.¹³ State penalties vary and can include voiding the note entirely, misdemeanor charges, or forfeiture of principal on top of interest.

1
Cornell Law School. Uniform Commercial Code 3-104 – Negotiable Instrument
2
Cornell Law School. Uniform Commercial Code 3-108 – Payable on Demand or at Definite Time
3
Justia. Reves v. Ernst and Young, 494 U.S. 56 (1990)
4
Cornell Law School. Uniform Commercial Code 3-401 – Signature
5
Cornell Law School. Uniform Commercial Code 3-301 – Person Entitled to Enforce Instrument
6
Cornell Law School. Uniform Commercial Code 3-302 – Holder in Due Course
7
Cornell Law School. Uniform Commercial Code 3-118 – Statute of Limitations
8
Cornell Law School. Uniform Commercial Code 3-601 – Discharge and Effect of Discharge
9
Cornell Law School. Uniform Commercial Code 3-311 – Accord and Satisfaction by Use of Instrument
10
Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID
11
Office of the Law Revision Counsel. 26 U.S. Code 7872 – Treatment of Loans With Below-Market Interest Rates
12
Internal Revenue Service. Revenue Ruling 2026-3 – Applicable Federal Rates for February 2026
13
Office of the Law Revision Counsel. 12 U.S. Code 86 – Usurious Interest – Penalty for Taking – Limitations