I wanted to start off with some of the basics:
1. What is a “promissory note?” A promissory note is a written promise to pay or repay a certain amount of money at a certain time, or in a certain number of installments, or on demand to a named person. It usually provides for payment of interest, and its payment can be secured by a deed of trust.
The person receiving the loan proceeds (borrower) becomes obligated to repay the debt by signing a promissory note which specifies: (1) the amount of the loan (principal); (2) the interest rate (interest); (3) the amount and frequency of payments (debt service); (4) when the borrower must repay the principal (due date); and (5) the penalties imposed if the borrower fails to timely pay or tender a payment (late charge) or decides to pay a portion or all of the principal prior to the due date (prepayment penalty). The promissory note identifies the borrower and the person who will receive the payments (lender or note holder).
2. How do you obtain a promissory note? You obtain a promissory note (become a lender or note holder) by either making a loan or purchasing an existing promissory note. Unless the loan is made or arranged by a real estate broker, a private party when making a loan will be subject to an interest rate ceiling. Charging a rate in excess of this ceiling is referred to as usury. Even when purchasing an existing promissory note (unless the purchase is arranged by a real estate broker), a private party, depending upon the fact situation, may still be subject to usury.
3. What secures your investment? Your investment is secured by a deed of trust recorded against the title of the borrower’s property (the Property). Unlike deposits in a bank or savings and loan, which are generally insured by a federal agency (such as FDIC) and may usually be withdrawn with limited notice, the promissory note: (1) involves some risk to principal (a typical feature of all investments); (2) establishes a specific and predetermined period of time for the repayment of your investment; and (3) does not benefit from insurance issued by a federal agency.
In a deed of trust, the borrower (trustor) transfers the Property, in trust, to an independent third party (trustee) who holds conditional title on behalf of the lender or note holder (beneficiary) for the purpose of exercising the following powers: (1) to reconvey the deed of trust once the borrower satisfies all obligations under the promissory note; or (2) to sell the Property if the borrower defaults (known as a foreclosure). Foreclosure involves the process of selling the Property to a third-party bidder or, in the absence of a sufficient third-party bid, acquiring title to the Property. The foreclosure sale, in most cases, satisfies the debt.