What is a Promissory Note?

We all dream of laying on the beach at some faraway island, no thoughts and worries, just blissfully thinking about what we want to do tomorrow. The farthest thing from our mind is how to pay for that life of leisure and freedom.

Is it possible to be worry-free about money and how you’re going to pay the bills? Yes, it is.

How can this be possible? Invest in promissory notes.

Promissory note investment takes some time, some money and lots of work to get an income stream rolling. However, it’s generally not as intensive as buying, fixing and flipping a house, or troublesome as being a landlord.

What is a Promissory Note?

A promissory note simply is a promise to pay. When you purchased your home or car, you probably signed a promissory note, promising to pay the lender back the money you borrowed. Essentially, the note contained repayment terms such as an interest rate, payment amount, the date payment is due, the length of the loan, the amount you borrowed and some terminology if you didn’t make the payments.

Promissory notes are commonly used for:

  • Credit card contracts
  • Student loans
  • Mortgages
  • Car loans
  • Business loans
  • Personal loans

 

There are generally two parties to the note: the lender and the borrower. You become the “note holder,” stepping into the “shoes” of the original lender when you invest in a promissory note.

Here’s an example of a simple promissory note:

 

In this example, John Doe borrowed $100,000.00 from ABC, Inc., at 5% interest for 360 months. The note is fully amortized, meaning it will be fully paid off at the end of 360 months. John agreed to pay $536.82 each month.  

Since the loan is fully amortized, each succeeding payment will have a small portion applied to the $100,000 principal, thus reducing it, with a larger portion applied to interest. Eventually, the interest is reduced and the principle amount increased.  Ultimately, in this example, the total interest paid after 360 months is $93,255.78.

For this note, the amortization schedule below begins with the July 1st payment; $120.15 is applied to principal, reducing the loan balance from $100,000 to $99,879.85. As you can see, $416.67 of the payment is applied to interest. With the August 1st payment, $120.65 is applied to principal reducing the loan balance to $99,759.20, with $416.17 applied to interest. So John made two monthly payments totaling $1,073.64 but only reduced the loan balance by $240.80! At the end of five years, John will still owe $92,740.67! Only until September 1, 2036, over 16 years later, will the monthly payment have more applied to the loan balance than interest. It is in the early years of the loan that the investor reaps the most interest. 

Often though, many loans are paid off within seven years, either through refinancing, or through the sale of the property.

 

Amortization Schedule of Payments

PMT # Date Payment Principal Interest Balance
1
Jul 1 2020
$536.82
$120.15
$416.67
$99,879.85
2
Aug 1 2020
$536.82
$120.65
$416.17
$99,759.20
3
Sep 1 2020
$536.82
$121.16
$415.66
$99,638.04
4
Oct 1 2020
$536.82
$121.66
$415.16
$99,516.38
5
Nov 1 2020
$536.82
$122.17
$414.65
$99,394.21
6
Dec 1 2020
$536.82
$122.68
$414.14
$99,271.53
Year 1
2020 Totals
$3,220.92
$728.47
$2,492.45
$99,271.53

Common Ways to Invest in Promissory Notes

Some of the more common methods for promissory note investment are:

  • Performing real estate notes – these notes are in good standing, with the borrower consistently making their monthly payments. Since it is a real estate note, real property secures the note. In the event of default, the lender/note holder has several avenues to pursue collection of the default.
  • Non-Performing real estate notes – these notes are also secured by real property, but the borrower is not making the promised payment. As the note holder, you need to invest time, effort, and often money to convince the borrower to start making payments. Failing that, you must foreclose on the property so you gain control. These notes can be good investments if you can accept the amount of work necessary, and the strategies needed to come out ahead.
  • Small business lending – new businesses often can’t obtain a loan from a traditional lender, therefore they may turn to private lenders. The loan creates a promissory note, generally secured by the business assets, but may include other property owned by the borrower, such the borrower’s residence. This lending can be risky for the lender as 45% of new businesses fail within the first five years and business assets depreciate quickly.
  • Peer-to-peer lending – sites like Prosper and Lending Club are popular as many of these clubs members are looking for short-term loans to make small purchases or consolidate debt. However, if the borrower defaults, collection may be difficult, especially if there are no tangible assets.

Why Invest in Promissory Notes

People have a variety of reasons for investing, but the most common is  replacing current income after retirement. Most people will automatically think about the stock market, with its variety of investment vehicles. 

While investing in the stock market is relatively simple and easy, there’s no guarantee that it will be profitable, or even safe! Although the market has reached record highs in the last four years, investors took major losses in the crash of 2007 and 2008. What we see are fluctuations, which can be random and stressful if you want to minimize risk.

With performing real estate notes there’s the consistency of the borrower making payments every month. For example, you purchase a $100,000 note with 7% interest, and a 240-month term for a discounted price of $90,000. Your monthly return is $775.30. That’s a solid path to reaching financial security.

Promissory notes, with their consistent income, can easily supplement other sources of income, such as wages, social security, or stock dividends. I suggest you consider including real estate backed promissory notes in your portfolio. 

Please remember though, no investment is risk free or guaranteed.  

Educating yourself about this investment opportunity is critical before you invest any money. And don’t feel that you need a huge amount of cash to invest. Many investors start small to test the waters and once they are comfortable, they invest more. But understand promissory notes before investing.

Don’t hesitate to call me at (360) 742-4640 if you have any questions. There is no sales pitch, and the call is free as is the education. Happy investing!

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