Promissory Notes-Not Understanding Promissory Note Lending Will Hurt You
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Background-Unsecured Notes
Making an investment or a loan based only on the borrowers promise to repay is called “unsecured lending”. A secured loan or investment has the borrower’s promise plus additional collateral security such as a lien on real estate or on a vehicle.
If an investor makes an unsecured loan or extends unsecured credit to a family member, friend or business contact, and the debtor defaults, intentionally or unintentionally, the investor faces a difficult decision. He can try to collect or accept a total loss. To collect an unsecured debt a legal action must be started and legal fees and court costs incurred. The goal is to obtain a judgment against the debtor. If the judgment is obtained, the creditor cannot expect repayment to happen automatically. He must then enforce the judgment (more fees and costs) by execution through the court and the sheriff. This is often a difficult and unrewarding process. Even worse, the debtor may file for bankruptcy, in which event, except in rare cases, the unsecured creditors receive little recovery.
The moral of this story: “don’t make an unsecured loan unless you are willing to suffer a loss—because you probably will”.
A Safer Way to Invest-Secured Notes
Having both a belt and suspenders holding up your trousers is safer than having just one. Similarly, having both a signature and collateral security supporting you promissory note is safer than having just on or the other.
What is Collateral Security?
It is the assignment or pledge of some asset, as additional protection, against a default on the note.
The pledged asset can be real property, a vehicle, furniture, fixtures and equipment, jewelry, a painting or any other valuable asset. It would only become important and useful if the promise of the debtor was not kept-if a default occurs. One of the best and most popular types of collateral security is real estate.
Real Estate as Collateral Security
Real property security instruments vary by state and consist primarily of:
Mortgages: The most common real property security instrument is a mortgage, which can encumber any interest in real property that can legally be transferred (including absolute ownership, a tenant’s interest under a lease, or the interest that a beneficiary of an easement holds). If the mortgagor (that is, the borrower, the party that granted the mortgage) fails to pay or perform an obligation, then the mortgagee (the holder of the mortgage, that is, the lender) can initiate an auction sale of the property, with the proceeds applied first toward the secured obligation.
Deeds of trust: The borrower under a deed of trust conveys title to any real property to a third party trustee, who can either re-convey it when the loan has been paid or hold a trustee’s sale if the loan is not paid. This puts the lender in the same position as if it held a mortgage.
Assignments of leases and rents: Assignments of leases and rents: An assignment of rents and leases is an agreement between the owner of a property and a designated second party. The terms and conditions allow that second party to collect any rental payments paid by tenants and to manage that property for a period of time. This type of arrangement is most commonly utilized to settle a loan or a credit extended by the second party to the property owner, and remains in effect until the debt is settled in full. For the duration of the assignment of rents, the property owner remains the owner of record for the property. There is no transfer of title, although the lender is usually given the privilege of managing the property as he or she sees fit. This means that for the duration of the agreement, the lender can use part of the collected proceeds to maintain the property, while applying the remainder of the collected rent payments toward the outstanding balance of the loan amount.
Summary
Making unsecured investments and loans is high risk; it is more risky than is necessary. The chance for a loss is significant. Making secured loans that have real estate collateral security is a much safer investment policy. The promissory note must be properly structure for maximum protection. To accomplish this work with experienced, knowledgeable professionals.
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Source by Lawrence Tepper
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