When people think of securing financing, they often translate it into "a loan from a bank." Loans are the core business of most banks, and interest is how they profit from them, but banks don't have a monopoly on lending. In fact, there is a way for anyone to become a lender: the promissory note. This article will look at how promissory notes work and how they may be used.
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Promissory notes are debt instruments that allow companies and individuals to get financing from a source other than a bank. This can be individuals or other companies who are willing to carry the note (provide the financing) under the agreed-upon terms. The terms include the interest rate, repayment schedule and the consequences of default. The difference between a promissory note and a simple IOU is that an IOU only states an amount that is owed to another party; a promissory note states the amount as well as the steps necessary to pay back the debt and the consequences if the lender should fail to do so.
Promissory notes have had an interesting history. At times, they have circulated as a form of alternate currency, free of government control. In some places, the currency is a form of promissory note called a demand promissory note (a note with no stated maturity date, allowing the lender to decide when to demand payment). In the United States, however, promissory notes have been issued only to corporate and sophisticated investors. Recently, however, promissory notes are also seeing increasing use when it comes to selling homes and securing mortgages. (For related reading, see From Barter To Banknotes.)
Promissory notes offer alternative credit for companies that have exhausted other options. The levels of credit a company can access, through corporate lending, bond issues and so on, is quite extensive. Therefore, a promissory note issued by a company is at a higher risk of default than, say, a corporate bond. This also means the interest rate on a corporate promissory note is likely to provide a greater return than a bond from the same company - high-risk means higher potential returns. (For more insight, see Corporate Bonds: An Introduction To Credit Risk.)
As mentioned before, these notes are only offered to corporate or sophisticated investors who can handle the risks and have the money needed to buy the note (notes can be issued for as large as sum as the buyer is willing to carry). The buyer can sell this note, or even the individual payments, to yet another buyer. In the case of such a sale, the note is purchased at a discount to its face value to account for the influence of inflation on the value of the payments in the future.
These notes have to be registered with the government in the state in which they are sold and/or with the Securities and Exchange Commission. Regulators will review the note to decide whether the company is capable of meeting its promises. If the note is not registered, the investor has to do his or her own analysis as to whether the company is capable of servicing the debt. In this case, the investor's legal avenues may be somewhat limited in the case of default. Companies in dire straits may hire high-commission brokers to push unregistered notes on the public. This problem became large enough that the NASD issued a general alert to investors. (To learn more, see the NASD alert: "Promissory Note Can Be Less Than Promised.")
The Take-Back Mortgage
Not everyone can get approved for a mortgage. Self-employed people typically have the hardest time because their incomes are not as regular or dependable as people in salaried positions. People who are between jobs or relocating to find work also fall to the wayside, no matter how much money they have saved up or how high their previous income level. As a result of most lenders' rigid attitudes towards these people, seller financing emerged as an alternative.
The promissory note is one of the ways in which people who don't qualify for a mortgage can purchase a home. The mechanics of the deal are quite simple: the seller continues to hold the mortgage (taking it back) and the buyer signs a promissory note saying that he or she will pay the price of the house plus an agreed upon interest rate in regular installments. Assuming the house has appreciated and/or the mortgage is paid off, the payments from the promissory note result in a positive monthly cash flow for the seller.
Usually, the buyer will put down a large down payment on the house to bolster the seller's confidence in the buyer's ability to keep his or her promise. Although it varies by situation and state, the deed of the house is often used as a form of collateral and it reverts back to the seller if the buyer can't make the payments. There are cases in which a third party acts as the creditor in a take-back mortgage instead of the seller, but this can make matters more complex and prone to legal problems in the case of default.
Looking at it from the perspective of the homeowner who wants to sell his or her house, the composition of the promissory note is quite important. It is better, from a tax perspective, to get a higher sales price for your home and charge the buyer a lower interest rate. This way, the capital gains will be tax free on the sale of the home, but the interest on the note will be taxed. Conversely, a low sales price and a high interest rate is better for the buyer because he or she will be able to write off the interest and, after faithfully paying the seller for a year or so, refinance at a lower interest rate through a traditional mortgage from a bank. Ironically, now that the buyer already owns the house, he or she probably won't have an issue getting financing from the bank to buy it. (To learn more, read The Mortgage Interest Tax Deduction.)
Investing In Promissory Notes
Investing in promissory notes, even in the case of a take-back mortgage, involves risk. There is the risk of default due to any of the many unpleasant surprises life may have in store for the person or corporation that creates the note to raise capital. To help minimize these risks, an investor needs to register the note or have it notarized so that the obligation is both publicly recorded and legal. Also, in the case of the take-back mortgage, the purchaser of the note may even go so far as to take out an insurance policy on the issuer's life. This is perfectly acceptable because if the issuer dies, the holder of the note will resume ownership of the house and related expenses that he or she may not be prepared to handle.
After an investor has agreed to the conditions of a promissory note, it can be sold to another investor, much like a security. Notes sell for a discount from their face values because of the effects of inflation on future payments. The money is worth less in the future. Other investors can also do a partial purchase of the note, buying the rights to a certain number of payments - once again, at a discount to the true value of each payment. This allows the note holder to raise a lump sum of money quickly, rather than waiting for payments to accumulate. (For a better explanation of how this works, read Understanding The Time Value Of Money.)
The Bottom Line
By bypassing the banks and traditional lenders, investors in promissory notes are taking on the risk of the banking industry without having the organizational size to minimize that risk by spreading it out over thousands of loans. This risk translates into larger returns - provided that the issuer doesn't default on the note. In the corporate world, such notes are rarely sold to the public. When they are, it is usually at the behest of a struggling company working through unscrupulous brokers who are willing to sell promissory notes that the company may not be able to honor.
In the case of take-back mortgages, promissory notes have become a valuable tool to complete sales that would otherwise be held up by financing. This can be a win-win situation for both the seller and buyer, as long as both parties fully understand what they are getting into. If you are looking to perform a take-back mortgage purchase or sale, you should have a talk with a legal professional and visit the notary office before you sign anything.
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