Many lenders do not provide financing without security. A promissory note is a contract between the bank and the borrower. A secured promissory note is accompanied by other documentation that pledges collateral. The borrower pledges this collateral in the event he can no longer pay and the loan is declared in default.
Secured vs. Unsecured
A secured note is accompanied by collateral. In the event the borrower fails to pay back the loan, the lender can legally seize and sell the collateral to recoup its losses. For this reason, lenders prefer notes to be secured. If an unsecured note goes unpaid, the lender can pursue legal action and file a judgment, but if the borrower does not have the means to repay, the lender will end up taking a loss. Unsecured notes are typically given to borrowers with excellent credit and high net worth.
The Promissory Note
The format of promissory notes differs by lender, but the content is similar. The first paragraph identifies the lender and borrower. Next, the note will describe the terms of the deal including principal amount, interest rate and maturity date. After the terms, the document lists several recitals. A recital is a statement of the facts of the transaction. Since the note is secured, one of the recitals will describe the security instrument. A security instrument can be a number of documents including a mortgage, assignment, security agreement, UCC (uniform commercial code) financing statement or pledge agreement. It will read similar to, “Whereas the borrower has entered into a Security Agreement dated May 23, 2012 as collateral for the loan.” The dates on the note and security agreement will be the same. This clause connects the promissory note and security agreement, in effect collateralizing the loan.
Securing the Note
The borrower will execute one or more security instruments in connection with the note. The type of security instrument is based on the type of collateral. Real estate is secured by a mortgage. Assets and equipment are encumbered via a security agreement in conjunction with a UCC financing statement. Accounts are secured by a pledge agreement. The security instrument will reference that the collateral is given in accordance with the promissory note of the same date. Mortgages and UCCs are recorded with the appropriate state and county authorities.
When a borrower begins to miss payments on a secured note, he will incur late charges. After 90 days of non-payment, the loan will be declared in default. Once this happens, the lender will begin to pursue legal action. The process will depend on a number of factors including the type of loan, the collateral and the state judicial process. When completed, ownership of the collateral will transfer to the bank. Since the lender rarely comes away without a loss after the costly legal process, it will usually work with a borrower in default before exercising its rights to the collateral. It may lower the interest rate, extend the repayment term or institute a temporary i period where the borrower pays only the interest.