The Promissory Note
A promissory note is a negotiable instrument. All negotiable instruments must contain these four elements:
A promise to pay a specific sum
A promise to pay a specific person or payable to the bearer
A promise to pay by a specific date or on demand
The signature of the maker
When a borrower on a residential real estate transaction signs a promissory note as the maker, the payee will be the lender. The lender is the owner of the note and can transfer its interest in the note to another entity. Unless the note contains language to the contrary, this is accomplished using an endorsement. An endorsement means that the payee, by way of signing the negotiable instrument, gives up the right to collect the money due.
Types of Promissory Notes
Promissory notes can be classified in a number of ways depending on how their terms are structured. The common classifications are: Straight Note, Amortized Note, Negative Amortization Note, Balloon Payment Note, and Note with Call Feature.
A straight note is a note with interest paid at periodic intervals, such as monthly, quarterly, semi-annually or annually, or the interest can accrue and be due at maturity. The principal payment is made in one payment at maturity (when the note becomes due) and is not paid in periodic intervals.
A straight note is seldom used for real estate loans but is often used for short-term debt. Other straight notes provide that interest will accrue and be due and payable upon the note maturity date.
An amortized note is a promissory note requiring the debt (both principal and interest) to be paid off in installments (regular payments). The amortized note is the most common type of promissory note used for real estate loans.
Negative Amortization Note
A negative amortization note is one in which the periodic installment payments on a loan are insufficient to pay all of the accrued interest. As a result, the unpaid interest is added to the principal amount of a mortgage loan causing the loan balance to increase rather than decrease. Negative amortization notes occur when:
the loan is a graduated-payment mortgage in which payments start at a level that does not pay all of the interest being charged, so the unpaid interest is added to the loan balance. The payments gradually increase at scheduled times until they finally level out at the amount needed to amortize.
the loan is an adjustable rate mortgage (ARM) with a payment cap. This loan allows the borrower to make payments that do not cover all of the interest being charged, while the lender adds unpaid interest to the principal balance.
the loan is an option payment ARM, which provides the borrower with the option to make payments to amortize the loan over 15 or 30 years, to pay interest only for a period, or to make minimum payments. Payments made under the minimum payment option do not cover all of the interest due and as a result, the interest is added to the principal balance.
the loan is a reverse mortgage that results in the loan balance increasing as loan proceeds are disbursed to the borrower and as interest is added to the balance.
Balloon Payment Note
A balloon payment note is a type of promissory note that requires one or more lump-sum payments. Most balloon notes are amortized over an agreed upon term, but require payment of an additional amount or the entire remaining amount before the end of that term. The payment date for the balloon payment is agreed upon when the note is made.
Clauses Attached to Promissory Notes
The majority of notes relating to real estate transactions contain one or more of the following clauses:
- Acceleration Clause - When a borrower defaults, an acceleration clause allows the lender to accelerate payment of the loan by requiring the entire principal balance immediately due and payable. Absent an acceleration clause, the lender can only require the borrower to bring the loan current.
- Late Charge - A late charge is a penalty for nonpayment or payments not made in a timely manner. Various federal and state laws impose restrictions on the amount and other issues relating to late charges.
Prepayment Clause - A clause in a note containing "not less than" allows the borrower to make payments of "more than" the amount mentioned, meaning early prepayment of the note is allowed.
The note might also state, "Monthly payments to be not more than $1000.00," which would not allow early payment, in full or in part. A clause written in such a manner is also referred to as a lock-in provision. Even if a note contains a clause permitting payments in excess of the minimum monthly installment payment, the note can restrict the amount that a borrower can prepay at any one time. These restrictions are usually tied to a percentage amount, a specified period, or both.
It should be noted that due to abuse current law restricts prepayment penalty clauses on mortgage loans.
Demand Clause - The demand clause is similar in concept to the acceleration clause, except the right to demand payment in full is not predicated upon a default by the borrower. Rather, it is at the will of the lender.
The demand clause is seldom used in real estate notes.