What it means
At its simplest, a promissory note is an IOU with legal teeth. It names the borrower (the maker), the lender (the payee), the principal amount, the interest rate, the repayment dates and what happens if a payment is missed.
Businesses meet promissory notes far more often than they expect. A shareholder lending the company working capital, a supplier converting an overdue invoice into a payment plan, and a bank issuing a term loan all rely on the same basic instrument.
The accounting treatment is straightforward but easy to get wrong. The borrower records the principal as a note payable (a liability) and books interest as an expense over time, while the lender records a note receivable (an asset) and books interest as income.
Notes come in two broad flavours. A demand note can be called by the lender at any time, so it stays a current liability, while a term note has a fixed maturity date and is split between current and non-current depending on when the instalments fall due.
The small print matters more than the headline rate. Security over specific assets, personal guarantees, default interest, prepayment penalties and the order of repayment relative to other creditors all change how expensive and how risky the note really is.
In practice
Real-world examples
Example 1
A software founder lends her own company $80,000 to cover a payroll gap and documents it as a promissory note at 6% simple annual interest, repayable in twelve months. A year later the company repays $84,800, being $80,000 of principal plus $4,800 of interest. The note keeps the loan clearly separate from equity, so her ownership percentage does not change.
Example 2
A commercial printer is owed $45,000 by a long-standing customer who cannot pay on time. Rather than write the balance off, the printer converts it into a promissory note at 5% over eighteen months with monthly instalments. The note gives the printer a dated, signed obligation it could take to court if the payments stop.
Example 3
When a family-owned bakery is sold for $800,000, the buyer pays $600,000 in cash and issues the seller a promissory note for the remaining $200,000 at 7%, repaid over three years. This seller financing bridges a gap the bank would not cover and keeps the seller invested in a smooth handover. Because the note is secured on the business assets, the seller can reclaim the bakery if the buyer defaults.
Think of it
Think of a promissory note as a written promise to bake a cake for your neighbour by next Tuesday, except instead of flour and sugar, you are dealing with money, interest, and legal consequences.
Formula
Calculation
For a simple-interest note: Interest = Principal x Annual Interest Rate x (Months / 12), and Total Repayment = Principal + Interest. Suppose a distribution business signs a promissory note for $250,000 at 8% simple annual interest, repayable in a single instalment nine months later. Interest = $250,000 x 0.08 x (9 / 12) = $250,000 x 0.06 = $15,000. Total repayment at maturity = $250,000 + $15,000 = $265,000. Spread evenly, the monthly interest cost is $15,000 / 9 = $1,666.67, which is the amount the borrower accrues in its accounts each month.Case study
Seen in the real world
Northgate Tooling, an illustrative fictional metal fabrication business, needed $300,000 to buy a second machining centre after winning a three-year supply contract. Its bank wanted six weeks and a full valuation, so the owners instead borrowed from a retired industry contact and documented the loan as a promissory note at 9% simple interest over a two-year term.
Interest across the full two years came to $300,000 x 0.09 x 2 = $54,000, giving a total repayment of $354,000. The new machine generated roughly $190,000 of additional gross profit a year, so the financing cost was comfortable relative to the return it funded.
The lesson in this fictional story is that the terms did the real work. The note allowed early repayment without penalty, so when bank funding finally came through in month fourteen the owners refinanced and paid only the interest accrued to that point, $27,000 x 14 / 12 = $31,500.
Watch out
Common mistakes
- Treating a note between friends or family as too informal to document properly, then discovering there is no agreed interest rate, maturity date or remedy when the relationship sours.
- Confusing the promissory note with the wider loan agreement; the note is the promise to pay, while the loan agreement carries the covenants, conditions and reporting obligations.
- Classifying the entire note as a long-term liability when the instalments due within the next twelve months belong in current liabilities.
Questions
People also ask
Is a promissory note the same as an IOU?
Not quite: an IOU only acknowledges that a debt exists, while a promissory note contains a binding promise to pay a stated amount on stated terms.
Does a promissory note have to be secured?
No, many are unsecured; security simply gives the lender a specific asset to claim on default, which usually buys the borrower a lower interest rate.
Can a promissory note be sold to somebody else?
Yes, if the note is negotiable it can be transferred or sold, and the buyer then has the right to collect the remaining payments.