Private Lending- Understanding Secured Versus Unsecured Promissory Notes

Before embarking on the adventure of private lending, it is crucial that you have an accurate understanding of notes and security instruments, specifically deeds of trust and mortgages. In this article, we will give you the knowledge you need about these tools to confidently move forward with your first private loan transaction.

So what is a promissory note?

A promissory note is a financial instrument that contains a written promise by one party (borrower) to pay another party (lender or note holder) a definite sum of money either on demand, within a certain number of installments, or at a specified future date.

A promissory note typically contains all the terms pertaining to the indebtedness by the issuer or maker to the note’s payee, such as the amount, interest rate, maturity date, date and place of issuance, and issuer’s signature, and its payment can be secured by a deed of trust.

There are two types of promissory notes: secured and unsecured.

For example, let’s say that Susan borrows $100,000 from Robert. To add an incentive to Robert for him to make the loan, Susan offers her house as security. This means that if Susan does not pay Robert back the $100,000 in full, Robert can seize Susan’s house to get back the money he lent her. This is a secured promissory note.

An unsecured promissory note has nothing material to protect it. Simply put, if you lend money through an unsecured promissory note, you must be prepared and accept the risk that you may lose your investment.

By signing a secured promissory note, the borrower accepts the obligation to repay the debt, specifying:

  • the loan amount (principal)
  • the interest rate
  • the amount of and payment schedule
  • the due date or maturity date, by which the borrower agrees to repay the principal
  • the penalties imposed upon the borrower should the payments not be made in a timely fashion, or should the borrower repay all or some of the principal prior to the date it is due (also known as a prepayment penalty).

As a private lender, you are ONLY interested in secured loans against real estate.

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