Shawn has a masters of public administration, JD, and a BA in political science.
Xander is a first-time homebuyer who has been approved for a loan sufficient to purchase the house he wants. He's going to be bombarded with a mountain of paperwork at the closing of the sale. One of the most important legal documents that he must understand and carefully review before signing is the promissory note.
A promissory note is an unconditional written and signed promise to pay a specific sum of money (which can include interest) on demand or on a specific date. We often refer to a promissory note as simply a note. The person that makes the promise is called the maker, and the person who is entitled to payment is the payee. Xander is the maker, and his bank will be the payee. The maker signs the note, but the payee doesn't have to do so.
A negotiable promissory note is one where the payee can negotiate (i.e., transfer) it to another party who becomes its holder. If a payee negotiates the note, its new holder is entitled to be paid. For example, Xander's bank may sell Xander's note to another bank. That bank will become the holder and will be entitled to payment from Xander.
A holder that takes a note in exchange for something of value, in good faith and doesn't have notice of any claims or defects regarding the note is called a holder in due course. Xander will have very few defenses against a holder in due course who goes to court to collect on the note, which is why lenders can easily sell promissory notes to investors.
A loan agreement is a contract where a lender agrees to lend money to a borrower. If a loan agreement is in writing, both parties sign it. It is often a much longer and complex document than a note. While a promissory note is pretty much limited to the unconditional promise to pay a certain sum of money on demand or on a specific date, a loan agreement will usually incorporate all promises, rights and obligations undertaken by both parties concerning the real estate loan. Lenders will often use a loan agreement that will require the borrower to make a promissory note and give a mortgage (or deed of trust).
Mortgage & Deed of Trust
Xander's bank thinks he's a good credit risk, but it's in business to make money as safely as possible, and it isn't going to give Xander the amount of money necessary to buy a house based on his mere promise. The bank will demand a mortgage on the house he is buying with the loan.
A mortgage is not a loan; it is an interest in real estate given to a lender by a borrower to secure payment of a loan. Should Xander fail to pay his loan, the mortgage empowers the bank to go to court to seek foreclosure of Xander's house, where the sales proceeds will be given to the bank to satisfy the outstanding loan balance.
In some states, a bank will take a deed of trust instead of a mortgage. In this case, Xander deeds legal title to the property to a neutral third party - called a trustee - who will hold the property for the benefit of the lender. Should Xander default, the trustee will sell the property at an auction and use the sale proceeds to satisfy the outstanding balance of the defaulted loan.
Let's review what we've learned. A promissory note is a written and signed unconditional promise to pay a specific sum of money upon demand or on a certain date. The party that makes the promise is called the maker, and the party that initially receives the note is the payee. If a note is negotiable, the payee may transfer the note to another who is called a holder. A holder in due course is a party that takes a note for value, in good faith and without notice of any adverse claim or defect concerning it.
A promissory note should not be confused with a loan agreement or mortgage. A loan agreement is an agreement between a lender and borrower that encompasses the promises, rights and obligations of both parties. A loan agreement will often require the borrower give the lender a promissory note as well as a mortgage. A mortgage is legal document given by the borrower to the lender to secure payment of the loan. A deed of trust is used in states that don't use mortgages and also serves to secure payment of the loan for the lender should the borrower default.
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