A payment note, more commonly called a promissory note, is a signed written promise to repay a specific amount of money on defined terms. It names the borrower and the lender, states the principal, sets the interest rate and repayment schedule, and spells out what happens if payments stop. Once signed, it is an enforceable contract that a court can act on, and in most cases it is also a negotiable instrument the lender can sell to someone else.
Payment Note vs. IOU
People use “IOU” and “promissory note” interchangeably, but they are not the same document. An IOU acknowledges that money is owed and stops there. A payment note contains an unconditional promise to pay a fixed amount on a specific schedule, with defined consequences for missing a payment.
That gap matters because a properly drafted payment note qualifies as a negotiable instrument under Article 3 of the Uniform Commercial Code, which every state has adopted in some form. Negotiable status means the note can be transferred to a new holder who then has the legal right to collect, even if the original lender is no longer in the picture. An IOU cannot do that. For any loan large enough that you would sue to collect, you want a note.
What Has to Be in the Note
A payment note does not need to be long, but it needs certain elements to hold up in court and keep its negotiable status. Missing one can knock it down to an ordinary contract or make it unenforceable altogether.
- Full legal names and contact information for the borrower (the maker) and the lender (the payee).
- The principal amount, written in both numbers and words to prevent disputes.
- The annual interest rate, within the state’s usury limits.
- The repayment schedule: monthly installments, a lump sum at maturity, or payment on demand.
- A definite maturity date, which is one of the requirements for negotiability.
- The borrower’s signature. Without it, no one is liable on the instrument.
Most well-drafted notes also include an acceleration clause. That provision lets the lender declare the entire remaining balance due at once if the borrower misses a payment or files for bankruptcy, instead of waiting for each installment to come due. Late fees should be spelled out, either as a percentage of the missed payment or a flat dollar amount. The CFPB’s model note form has a blank for a percentage-based late fee that kicks in after a set number of calendar days past the due date.1Consumer Financial Protection Bureau. Multistate Fixed Rate Note Whatever penalty you set has to be reasonable. Courts will not enforce a late fee that looks more like a punishment than compensation for the lender’s actual costs.
Interest Rate Rules You Cannot Ignore
Every state caps how much interest a lender can charge. The caps vary by loan type, amount, and who is lending. Charging over the ceiling is usury, and the penalty can range from losing the excess interest to voiding the loan entirely. Before setting a rate on a private note, look up the specific limits in your state.
The IRS Minimum Rate
Even on informal loans between family or friends, the IRS requires you to charge at least the Applicable Federal Rate, published monthly. For January 2026, the annual AFRs are 3.63% for short-term loans (up to three years), 3.81% for mid-term loans (three to nine years), and 4.63% for long-term loans (over nine years).2Internal Revenue Service. Revenue Ruling 2026-2
Charge less than the AFR (or nothing) and the IRS treats the shortfall as “forgone interest.” That phantom interest is taxed as if the lender actually received it, and the forgone amount can also count as a gift from lender to borrower.3Office of the Law Revision Counsel. 26 US Code 7872 – Treatment of Loans with Below-Market Interest Rates
There is a small carve-out. If total loans between you and the other individual stay at or below $10,000, the imputed interest rules generally do not apply. That exception disappears if the borrower uses the money to buy income-producing assets like stocks or a rental property.3Office of the Law Revision Counsel. 26 US Code 7872 – Treatment of Loans with Below-Market Interest Rates
Reporting the Interest
Interest of $10 or more in a year has to be reported to the IRS. Institutional lenders file Form 1099-INT with the borrower’s information.4Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID Private individual lenders are not always required to issue a 1099-INT, but the interest is still taxable and belongs on the lender’s return. Borrowers can generally deduct mortgage interest on a secured note but not interest on a personal loan.
Types of Payment Notes
Secured or Unsecured
A secured note is backed by collateral. In real estate, the note and the mortgage (or deed of trust) work as a pair. The note creates the obligation to repay, and the mortgage gives the lender the right to seize and sell the property if the borrower defaults.5U.S. Securities and Exchange Commission. Promissory Note Secured by Deed of Trust This two-document setup is standard for home purchases, commercial real estate, and most car loans.
An unsecured note has no collateral. Loans between friends, some business financing, and commercial paper issued by large corporations to raise short-term capital all typically use unsecured notes. The lender’s only remedy on default is to sue for a money judgment and try to collect from the borrower’s general assets.
Recourse or Non-Recourse
This one matters most when a secured note goes bad and the collateral is not worth enough to cover the debt. On a recourse note, the lender can chase the borrower personally for the shortfall through wage garnishment or bank account levies. On a non-recourse note, the lender’s recovery is limited to the collateral, and nothing more.6Internal Revenue Service. Cancellation of Debt – Basics – Recourse vs Nonrecourse Debt Whether a loan is recourse or non-recourse depends on the note’s terms and state law. This single detail can mean the difference between walking away and owing a large deficiency balance.
Demand or Term
A term note has a fixed schedule and a definite maturity date. A demand note has no set due date; the lender can call the full balance due at any time by giving notice. Demand notes are common on lines of credit and some business loans. They give the lender flexibility and leave the borrower needing to be ready to pay at any moment.
When the Note Gets Sold
One of the more surprising features of a payment note is that the original lender does not have to wait years to be made whole. The note itself is an asset, and it can be sold to an investor who then collects the remaining payments, usually at a discount off the face value.
The transfer happens by endorsement. The current holder signs the back of the note, much like endorsing a check. A blank endorsement, where the holder just signs without naming a new payee, turns the note into a bearer instrument that whoever holds it can collect on. A special endorsement names a specific new payee, and only that person can collect or pass it along. Special endorsements are safer, because a lost or stolen note with a blank endorsement is essentially cash in the wrong hands.
The new holder steps into the original lender’s shoes and can enforce the note against the borrower. The strongest position that new holder can reach is “holder in due course” status. To qualify, the buyer must have paid value for the note, acted in good faith, and had no knowledge of any problem with it at the time of purchase.
Holder in due course status strips away most defenses the borrower could have raised against the original lender. If the original lender breached a side agreement, the borrower still owes the holder in due course. Only a narrow set of defenses survives: fraud that tricked the borrower into signing without understanding what the document was, infancy, duress, illegality, and discharge in bankruptcy.7Legal Information Institute. UCC 3-305 – Defenses and Claims in Recoupment Everything else is cut off. Borrowers sometimes learn this the hard way when they stop paying over a dispute with the original lender and find the note has been sold to someone immune to that argument.
What Default Triggers
Default usually means a missed payment, but the note itself controls what counts. Some notes also treat a lapsed insurance payment or a drop in collateral value as a default event.
The lender’s first move is typically to invoke the acceleration clause and make the full unpaid balance due at once. What happens next depends on whether the note is secured.
On an unsecured note, the lender sues for a money judgment covering the outstanding balance, accrued interest, and late fees. If the court grants judgment, collection can proceed through wage garnishment, bank levies, and liens on the borrower’s property, all subject to state exemption laws that protect certain assets and income.
On a secured mortgage note, the lender can foreclose. Depending on the state, that happens through a court proceeding (judicial foreclosure) or a trustee sale without court involvement (non-judicial foreclosure). The property is sold and the proceeds go toward the debt.
This is where recourse status becomes critical. If the sale brings in less than what is owed, the gap is called a deficiency. On a recourse note, the lender can seek a deficiency judgment and then pursue the borrower’s other assets and income. Most states allow deficiency judgments; a handful, including Alaska, California, Minnesota, Montana, Oregon, and Washington, prohibit them in most circumstances. On a non-recourse note, the lender absorbs the loss.6Internal Revenue Service. Cancellation of Debt – Basics – Recourse vs Nonrecourse Debt
How Long the Lender Has to Sue
A lender does not have unlimited time to enforce a defaulted note. Under the UCC, the statute of limitations on a note payable at a definite time is six years from the stated due date. If the lender accelerated the balance after a default, the six years run from the acceleration date.8Legal Information Institute. UCC 3-118 – Statute of Limitations
Demand notes work differently. The six-year clock starts when the lender actually demands payment. If no demand is ever made, the note becomes unenforceable after ten continuous years without any payment of principal or interest.8Legal Information Institute. UCC 3-118 – Statute of Limitations Some states have adjusted these periods, so check local rules. The point holds: sit on a defaulted note too long and the courts stop being an option.
Paying Off the Note
When the borrower makes the final payment, the obligation is discharged. Under the UCC, the instrument is paid to the extent payment is made by the party who owes the debt to the person entitled to enforce it.9Legal Information Institute. UCC 3-602 – Payment The borrower should get the original note back marked “paid in full” or receive a written satisfaction from the lender. On a mortgage note, the lender also has to record a release or satisfaction of mortgage with the county recorder to clear the lien from the property’s title.
One detail catches borrowers off guard. If the note has been transferred, paying the original lender does not always discharge the debt. The borrower has to pay whoever currently holds the note. If the borrower gets proper written notice that the note has been sold and where to send payments, continuing to pay the old lender does not count.9Legal Information Institute. UCC 3-602 – Payment Confirm who holds the note before sending a final payoff, especially on a loan that may have moved through the secondary market.