Borrowing money often involves a written contract, also known as a promissory note, that guarantees repayment by the borrower to the lender. A note can have a single or multiple payers, and the right to collect on the note can be passed on from the original payee to another party. If you're involved in a lending transaction or are preparing to sign a promissory note, it's important to keep the various terms, definitions and legalities in mind.
Co-Makers, Co-Signers and Co-Obligations
In financial terms, the party that borrows money and signs a promissory note to guarantee repayment is the maker of the note. In addition, the lender may require a second party to bring his own good credit standing to the transaction, and sign the note to back up the original borrower's guarantee. Second and subsequent parties are known as co-makers or co-signers. They share fully in the obligation to repay the note in full, and will be liable for that repayment if the primary borrower defaults. The generally accepted rules for promissory notes, as well as definitions, are included in the Uniform Commercial Code.
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The party that lends the money on the guarantee of a promissory note is the original payee of that note; the individual or party in possession of the note -- usually the same -- is the holder. A payee may treat the note as another financial asset, such as a stock or bond, which he can transfer or sell to another party. In order to transfer the note, however, the payee must endorse it. An endorsement is a signature in which the payee makes a third party the new payee, who thus receives the right to collect from the maker and any co-maker. If no party is named as the new payee, the endorsement makes the note a bearer instrument. This means the holder, whoever he may be, becomes the payee. Notes can be endorsed multiple times, and the right to receive repayments can be split among multiple payees by terms included in or appended to the note.
Legal Rights and Obligations
Promissory notes are common in business transactions as a means to raise capital from banks, partners and investors. In a business partnership, an agreement spells out the right and obligations of the partners in regards to notes signed by one or all. An individual payee also may be acting on behalf of an employer, such as a bank. The employer has the right to the payments, in the terms given in the note: interest rate, frequency of payment, amount of payment, term of the note. If the maker and co-maker default, the payee can sue for repayment -- and, if the note is secured, seize property serving as a guarantee. These rights pass to the new payee if the note is endorsed. Before agree to participate as a co-maker or co-signer in a promissory note, an individual can minimize the risk by insisting on terms that will shelter him from full liability in case the issuer defaults.
Promissory notes can provide a steady stream of income to their holders, but they also have provided the means to defraud unsuspecting investors. A common criminal scheme is to offer promissory notes through life insurance agents, who provide a screen of legitimacy. The seller collects payment in full, then pays a short-lived stream of interest, as well as a commission to the agent, before absconding with the funds. To avoid these scams, check the promissory note's registration with the Securities and Exchange Commission or your state's financial services agency. Be suspicious of unsolicited offers of promissory notes, and of any debt instrument that promises a sky-high rate of interest. Finally, check with a financial adviser before going through with the purchase.