Many forms of loan agreements involve a promissory note, a legal promise to repay a debt. The note itself is legally enforceable, but does not secure the loan, meaning the lender has fewer rights in the event of a default or bankruptcy. As a result, the borrower and lender usually agree to a lien, a legal claim on an asset.
Legal Status
A promissory note is a legal document establishing an obligation to repay a debt. It contains similar information to an informal "IOU," but has a major difference. An IOU is merely an admission that a debt exists and does not, in itself, obligate the borrower to repay the money. A promissory note is a legally enforceable promise by the borrower to repay the money. In most cases, it details the agreed-upon repayment schedule.
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Drawbacks
The promissory note itself is an unsecured obligation. This does not change the fact that the borrower is legally obliged to repay the debt. However, if the borrower is declared bankrupt, a promissory note by itself will be lower in priority than secured debts. This means that the lenders will not get back any money until those with secured debts have been paid in full. In the event that there is only enough money to pay a portion of the money owed in secured debts, the lender of an unsecured debt will usually get no money at all.
Solutions
To overcome the security problem for lenders, most promissory notes are accompanied by a lien. This is an agreement between the borrower and the lender that, until the debt is repaid, the borrower has a legal claim on the asset that secures the debt. In the case of a promissory note, this is most commonly real estate property. The holder of a lien has the right to force the borrower to sell the asset to pay the debt in the event of a repayment default; the right to get back the outstanding loan balance from the proceeds if the borrower voluntarily sells the asset; and the right to a claim on the asset or the proceeds of a sale in the event of the borrower entering bankruptcy.
Uses
One form of loan that involves both a promissory note and a lien is an investment trust deed, in which one or more lenders provide the funds for a property loan, organized via a trust. This is different to a traditional mortgage, in which the legal powers contained in a promissory note and a lien are usually combined in a single mortgage agreement document.
Controversy
Some lawyers have argued that lenders should not be able to foreclose a property when the physical promissory note itself cannot be produced. This is a contentious issue and, as of 2010, was still inconclusive and being debated on a state-by-state basis.