When a promissory note maker fails to pay, the holder of the note can send a formal written demand, attempt to negotiate a modified payment or settlement, and, if neither works, sue for breach of contract to obtain a money judgment. What you can recover, how fast you can move, and whether you can seize property all depend on the note’s terms, whether collateral secures the debt, and how long ago the default occurred.
What Counts as a Default
Default means the borrower failed to do something the note required. A missed payment is the obvious trigger, but the note itself sets the full list. Late payments arriving after any grace period, failure to keep insurance on collateral, or missing the final lump-sum payment on the maturity date can all qualify depending on what the parties agreed to.
Look next for an acceleration clause. When triggered, it lets you demand the entire remaining balance immediately instead of chasing each future installment as it comes due.1Legal Information Institute. Acceleration Clause If a borrower owes $50,000 spread over five years and misses one payment, an acceleration clause lets you call the full $50,000 due now. Without one, you can only sue for the payments already missed.
Sending a Demand Letter
Start with direct contact. Sometimes a missed payment is an oversight, and a call or email resolves it. If informal contact goes nowhere, send a formal demand letter by certified mail or another method that proves delivery. The note itself or applicable law may require written notice before you can accelerate the debt or file suit, so skipping this step can create problems later.
A strong demand letter identifies both parties, references the original note by date and amount, and states exactly what is owed. Break the numbers out: unpaid principal, accrued interest, and any late fees the note authorizes. If you are invoking an acceleration clause, say so explicitly and demand the full accelerated balance. Set a firm deadline. State clearly that you will pursue legal action if the deadline passes. If the note allows recovery of attorney’s fees and court costs, mention that too. Keep the tone businesslike; the letter may end up as evidence.
Negotiating Before a Lawsuit
Litigation is expensive and slow, and a judgment is only as good as the borrower’s ability to pay it. If the borrower’s trouble looks temporary, a modified payment schedule, a short stretch of interest-only payments, or an extended timeline may recover more than a lawsuit would. If the borrower has some cash but clearly cannot pay in full, a discounted lump-sum settlement can put more in your pocket than a drawn-out fight.
Put any agreement in writing, signed by both parties. A verbal promise to accept reduced payments is nearly impossible to enforce if the borrower slips again.
Filing a Lawsuit for Non-Payment
If demand and negotiation fail, the next step is a breach of contract lawsuit asking a court to order the borrower to pay.
To win, you generally need to prove four things: the note exists and the borrower signed it, you actually loaned the money, the borrower failed to pay as required, and you are owed a specific amount. Original documents matter. Keep the signed note, records of the loan disbursement, a payment history showing what was and was not received, and copies of your demand letter with proof of delivery.
Choosing the Right Court
If the amount owed falls within your local small claims court limit, that route is worth considering. Small claims limits vary widely by jurisdiction, running roughly from $2,500 to $25,000 depending on where you file. The process is faster, cheaper, and designed for people without attorneys. Larger amounts require a court of general jurisdiction, where procedure is more complex and an attorney becomes important.
What You Can Recover
The main recovery is the unpaid balance: principal plus interest at the rate stated in the note. If the note provides for late fees, attorney’s fees, or collection costs, you can seek those as well. Many jurisdictions also allow prejudgment interest for the time between default and judgment. Whether prejudgment interest applies, and at what rate, depends on your jurisdiction and the note’s terms.
Secured vs. Unsecured Notes
Whether the note is backed by collateral is the single biggest factor shaping your options.
Secured Notes
A secured note is backed by specific property such as real estate, a vehicle, or equipment. On default, you have the right to seize that property. For real estate, that means foreclosure. For personal property like a car, it means repossession. In many states, a lender can repossess a vehicle without going to court first, as long as they do not breach the peace in the process.2Federal Trade Commission. Vehicle Repossession
Seizing collateral does not always end the matter. If you repossess and sell a car for $12,000 but the borrower owed $20,000, the $8,000 gap is a deficiency. In most states, you can pursue a deficiency judgment for that remainder, but only if you followed proper procedure during the repossession and sale. The sale must be conducted in a commercially reasonable manner, and you generally must give the borrower advance notice of the sale. Cutting corners on either point can wipe out your right to collect the deficiency.
Unsecured Notes
An unsecured note has no collateral behind it. Your only remedy is to sue, obtain a money judgment, and use that judgment to reach the borrower’s assets. If the borrower has no meaningful assets or income, a judgment may not be worth much. Evaluating the borrower’s financial picture before spending money on litigation is a step experienced lenders never skip.
Collecting on a Judgment
Winning gets you a judgment, not cash. Collection is a separate fight.
The two most common tools are wage garnishment and bank account levies. Federal law caps wage garnishment for ordinary debts at the lesser of 25% of the borrower’s disposable earnings per week or the amount by which their weekly disposable earnings exceed 30 times the federal minimum wage.3Office of the Law Revision Counsel. United States Code Title 15 – 1673 Restriction on Garnishment Some states impose tighter limits. A bank levy reaches funds in the borrower’s bank account, though certain amounts may be exempt depending on the source of the funds and local law.
If the borrower owns real property, recording your judgment places a lien on it. The lien attaches to the property and must be paid when it is sold or refinanced. Slow, but effective when the borrower has home equity and you have patience.
The Deadline to Sue
Every note has an expiration date for enforcement, and missing it means losing the right to collect. Under the Uniform Commercial Code, a suit to enforce a note payable on a definite date must be filed within six years of that date. If you accelerated the debt, the six-year clock starts from the accelerated due date. For demand notes where a demand was made, you have six years from the demand. If you hold a demand note and never make a demand, the right to sue expires after 10 years of receiving no payments of principal or interest.4Legal Information Institute. UCC 3-118 Statute of Limitations
States can and do modify these defaults. Limitation periods for promissory notes range from as few as three years to as many as fifteen depending on the state. Check your state’s statute before assuming you have six years. Once the deadline passes, the borrower can raise it as a complete defense, and the court will dismiss the case no matter how strong the underlying claim is.
Defenses the Borrower Might Raise
A promissory note is an unconditional promise to pay, so valid defenses are narrower than in a typical contract dispute. The common ones:
- Already paid. The borrower claims the debt was satisfied in whole or in part. Detailed payment records are the answer.
- Fraud or duress. The borrower argues they were deceived into signing or signed under threat, attacking the formation of the agreement itself.
- Lack of consideration. The borrower claims the money was never actually loaned. Rare when bank records or wire confirmations exist; more common with handshake loans.
- Statute of limitations. The borrower argues you waited too long. This is an absolute bar if the deadline has passed.
- Material alteration. The borrower claims the note was changed after signing without consent, such as an altered interest rate or principal.
Documentation is the best protection against all of these. Store the original signed note safely, keep records showing the loan was disbursed, log every payment, and preserve correspondence.
If the Borrower Files Bankruptcy
A bankruptcy filing changes the situation immediately. The moment the petition is filed, an automatic stay takes effect and prohibits you from continuing any collection activity. No calls, no pending lawsuit, no wage garnishment, no repossession without first getting permission from the bankruptcy court.5Office of the Law Revision Counsel. United States Code Title 11 – 362 Automatic Stay Violating the stay can bring sanctions.
In a Chapter 7, an unsecured promissory note is generally dischargeable, meaning the borrower’s obligation to pay it can be wiped out. Clauses in the note trying to block discharge are unenforceable. One exception matters: if the borrower obtained the loan through fraud or material misrepresentation, you can file an adversary proceeding arguing the debt should survive the discharge. Debts obtained by false pretenses or actual fraud are nondischargeable if you can prove it.
For secured notes, bankruptcy does not automatically eliminate your lien. The borrower may be able to discharge personal liability for the remaining balance, but your security interest in the collateral generally survives. You can file a motion for relief from the automatic stay to proceed with repossession or foreclosure if the borrower is not making payments on the secured debt during the case.
Tax Consequences If the Note Goes Unpaid
Bad Debt Deduction for the Lender
If you loaned money on a promissory note that has become uncollectible, you may be able to claim a bad debt deduction on your federal taxes. For a personal loan outside your trade or business, the IRS treats this as a nonbusiness bad debt. You must show the money was intended as a loan and not a gift, that you previously included the amount in your income or loaned out your own cash, and that the debt is completely worthless with no reasonable expectation of repayment.6Internal Revenue Service. Topic no. 453, Bad Debt Deduction
A nonbusiness bad debt must be totally worthless to qualify; a partially uncollectible personal loan does not. You also need to show reasonable collection efforts, though going to court is not required if you can demonstrate a judgment would be uncollectible anyway. The deduction is reported as a short-term capital loss and is subject to capital loss limitations. Attach a statement to your return describing the debt, the borrower, your collection efforts, and why you concluded the debt was worthless.6Internal Revenue Service. Topic no. 453, Bad Debt Deduction
Cancellation of Debt Income for the Borrower
If you formally cancel or forgive $600 or more of the debt, an applicable financial entity is required to file Form 1099-C with the IRS, reporting the cancelled amount as income to the borrower.7Internal Revenue Service. About Form 1099-C, Cancellation of Debt Even where the form is not required, the borrower may still owe tax on forgiven debt. That tax exposure sometimes becomes a negotiation point in settlement discussions.
A Note on the FDCPA
If you are the original lender collecting on your own promissory note, the federal Fair Debt Collection Practices Act generally does not apply to you. The FDCPA defines a “debt collector” as someone who collects debts owed to another or whose principal business is debt collection, and officers and employees of a creditor collecting in the creditor’s own name are excluded.8Federal Trade Commission. Fair Debt Collection Practices Act
One trap: if you collect under a name other than your own in a way that suggests a third party is collecting, you lose that exemption and become subject to the full range of FDCPA restrictions, including limits on when and how you can contact the borrower.8Federal Trade Commission. Fair Debt Collection Practices Act A collection agency or an attorney whose principal business is debt collection is fully subject to the FDCPA even though you as the original lender were not.