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 fixed date or on demand. It goes further than a casual IOU by spelling out the repayment terms: how much, when, and at what interest rate. When drafted to meet the requirements of the Uniform Commercial Code, a promissory note is a negotiable instrument, meaning the payee can sell or transfer the right to collect to a third party.1Legal Information Institute. Uniform Commercial Code 3-104 – Negotiable Instrument
That single document does a lot of work. It creates a debt, sets its price, defines what breaking the deal looks like, and gives the lender a paper trail to enforce in court. Mortgages, car loans, student loans, seller-financed business sales, and family loans all rely on one.
What Has to Be In One
UCC Section 3-104 sets a short floor. A negotiable promissory note has to 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. It can’t require the maker to do anything beyond paying money, apart from narrow exceptions like pledging collateral or waiving certain legal protections.1Legal Information Institute. Uniform Commercial Code 3-104 – Negotiable Instrument
That’s the floor, not the ceiling. A note that only clears the statutory minimum will be hard to enforce in practice. A workable promissory note also spells out:
- Full names and addresses of the maker and payee.
- The principal amount as an exact dollar figure.
- The interest rate and how it’s calculated (fixed, variable, or explicitly zero).
- A payment schedule with amounts, frequency, and the first due date.
- The maturity date when the final payment is owed.
- Default provisions defining what counts as a breach and what happens next.
- A governing law clause naming which state’s law controls interpretation.
Without clear terms on payment schedule and default triggers, enforcing the note in court gets expensive and uncertain even if the UCC box is checked. Vague material terms can also run into the general contract-law requirement that an agreement be definite enough for a court to figure out what each side owes.
The maker’s signature is the one formality you can’t skip. The payee doesn’t need to sign. Some states require notarization for notes secured by real estate; even where it isn’t required, notarizing the maker’s signature makes future forgery claims harder to bring and generally costs under $25.
The Main Types
Installment Notes and Demand Notes
An installment note is what most people picture: regular payments of principal and interest over a set period until the balance hits zero. Mortgages, car loans, and student loans all use this structure. The maker knows the monthly obligation; the payee knows when the debt retires.
A demand note has no fixed schedule. The payee can call the entire balance due at any time, usually after reasonable notice.2Legal Information Institute. Demand Note Demand notes show up in short-term business financing and loans between family or business partners. Flexibility cuts both ways: the maker can often repay comfortably as long as the lender stays happy, but there’s no guaranteed timeline.
Secured Versus Unsecured
A secured note ties repayment to a specific asset: real estate, a vehicle, business equipment. If the maker stops paying, the payee can seize and sell the collateral to recover what’s owed. Because the payee has that fallback, secured notes carry lower interest rates and are easier to obtain, especially for large amounts.
An unsecured note rests on the maker’s promise and creditworthiness alone. There’s no collateral to claim if things go wrong, so unsecured notes carry higher rates. Personal loans between individuals and most credit card debt fall in this category.
Convertible Notes
In startup financing, a convertible note lets an investor lend money that later converts into equity instead of being repaid in cash. The most common trigger is a future fundraising round that meets a minimum size; some notes also convert at maturity or on a sale of the company. The structure lets early investors put capital to work without having to value a brand-new company.
Interest Rate Rules That Catch People Out
Every state caps the interest rate a private lender can charge, and the ceilings vary dramatically. 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 above your state’s cap can void the interest, make the note unenforceable, or trigger penalties. Check the usury statute before setting a rate on any private note.
Charging too little interest creates the opposite problem. Under Internal Revenue Code Section 7872, when you issue a loan below the IRS’s Applicable Federal Rate (AFR), the IRS treats the shortfall as imputed interest. The lender owes tax on that phantom interest even though no cash changed hands. For January 2026, the AFR runs from 3.63% annually on short-term loans (three years or less) up 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 each month, so check the rate in effect when you issue the note.
This bites hardest on family loans. Lend your child $200,000 at 0% on a ten-year note and the IRS will impute interest at the long-term AFR each year and tax you on it. The forgone interest can also be treated as a gift to the borrower. The clean fix: charge at least the AFR and document the loan with a proper promissory note and repayment schedule. Without that paperwork, the IRS can reclassify the whole loan as a gift. For 2026, the annual gift tax exclusion is $19,000 per recipient, so anything recharacterized above that threshold starts eating into your lifetime exemption.
What Each Side Can and Must Do
The maker’s core obligation is simple: pay 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 matching right is to receive those payments on schedule. Most notes let the payee charge late fees after a defined grace period, but only if the fee is spelled out in the original document. A payee trying to impose late fees that were never disclosed will struggle to collect them.
Paying Off Early
Whether you can prepay depends on the note. Many consumer loan agreements allow early payoff without penalty, and some states outright prohibit prepayment penalties on certain loans.4Consumer Financial Protection Bureau. Can I Prepay My Loan at Any Time Without Penalty Commercial notes often include a prepayment penalty to make up for interest the payee loses when the loan ends early.5Legal Information Institute. Prepayment Penalty If the note is silent, the default rule in most jurisdictions allows early payoff without penalty, but confirm before writing a large check.
Co-signers and Guarantors
When the maker’s credit or income isn’t enough on its own, the payee may want a third party on the note. Co-signers and guarantors both back the debt, but their exposure isn’t the same. A co-signer is on the hook from day one; miss a single payment and the payee can pursue the co-signer immediately for that amount. A guarantor’s liability kicks in only after the maker has fully defaulted, meaning the payee generally has to exhaust efforts against the maker first. Understand which one you’re being asked to be before you sign.
When Payments Stop
A default happens when the maker breaks a term of the note. Missing a payment is the obvious trigger, but the note can define default more broadly, covering things like failing to maintain insurance on collateral or filing for bankruptcy. How default is defined controls how fast the payee’s enforcement rights come online.
Acceleration
The single most consequential clause in most promissory notes is acceleration. When triggered, the entire remaining balance becomes due at once instead of continuing on schedule. A maker who is $500 behind on a $100,000 note can suddenly owe the full $100,000. Acceleration isn’t always automatic. In many notes, the payee has to choose to invoke it, and if the maker cures the default before that happens, the right to accelerate may be lost. That cure window is worth negotiating if you’re the borrower.
Enforcing a Secured Note
When a secured note defaults, the payee can take and sell the collateral. For real estate, that means foreclosure. For personal property like equipment or vehicles, UCC Article 9 controls repossession and sale. Sale proceeds go toward the debt; if the sale doesn’t cover the full balance, the payee can pursue the maker for the deficiency in most states.
Enforcing an Unsecured Note
Without collateral, the payee’s only route is a civil lawsuit. A judgment for the payee opens the door to wage garnishment and bank account levies.6Consumer Financial Protection Bureau. Can a Debt Collector Take or Garnish My Wages or Benefits Federal law caps how much of a paycheck a creditor can garnish, and state exemption laws may protect additional wages or property.7U.S. Department of Labor. Garnishment Many notes also make the defaulting maker responsible for the payee’s attorney fees and court costs, which can add up fast.
How Long the Payee Has to Sue
Payees can’t wait forever. 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 six years run from the accelerated due date. For demand notes where a demand was actually made, the clock starts on the demand date. If no demand is ever made and no payments of principal or interest happen for ten straight years, the claim is barred entirely.8Legal Information Institute. Uniform Commercial Code 3-118 – Statute of Limitations These are the UCC defaults; some states set shorter or longer periods, so check your jurisdiction.
Tax Surprises for Both Sides
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 canceling $600 or more must file Form 1099-C, and the maker has to report the forgiven amount as other income on their return.9Internal Revenue Service. About Form 1099-C, Cancellation of Debt Exceptions exist for insolvency and bankruptcy, but otherwise a $50,000 settlement can produce a tax bill of several thousand dollars.10Internal Revenue Service. Form 1099-C – Cancellation of Debt
The second trap hits lenders, especially inside families. Lending below the Applicable Federal Rate triggers imputed interest under IRC Section 7872, so the IRS treats you as having earned interest whether you collected it or not.3Internal Revenue Service. Revenue Ruling 2026-2 – Applicable Federal Rates And if a family loan lacks a written promissory note, a reasonable rate, and an actual repayment history, the IRS can reclassify the transaction as a gift. Above the $19,000 annual gift tax exclusion per recipient, that reclassification starts reducing your lifetime estate and gift tax exemption. The defense is a signed note at or above the AFR, a repayment schedule the borrower actually follows, and records showing payments arrived on time.