Key Takeaways
- A note is a short- to medium-term debt instrument that the lender expects to be repaid, plus interest, and the terms vary for each type of note.
- The most common types of notes include promissory notes, mortgage notes, and Treasury notes.
- Specifically, U.S. Treasuries are considered safe investments because they are fully backed by the U.S. government.
- Lenders sometimes sell notes on a secondary market, which is purchasable by individual investors.
Definition and Examples of a Note in Finance
A note is a type of debt instrument a borrower must repay plus interest, typically over a set period of time. In simpler terms, notes serve as a legal promise that a debt, plus interest, will be repaid. Depending on the type of note, the structure used to decide when and how the funds will be paid will differ. Generally, repayment terms range from two to 10 years.
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Treasury notes specifically are issued in maturities of two, three, five, and 10 years.
There are several different types of notes, including government-issued notes, mortgage notes, and convertible notes.
- Alternate name: Notes payable
A Treasury note, or T-note, is generally the most common example of a note. Let’s say you purchase a T-note for $10,000 with a five-year term. In this scenario, you are the lender and the U.S. government is the borrower. Every six months, the government pays a portion of the principal plus interest over the course of five years. By the end of the five-year term, you have made back your principal and more.
How Does a Note in Finance Work?
As mentioned, a note serves as a promise that a borrower must repay a debt plus interest, typically over a set period of time. Notes function similarly to bonds. Both are types of debt securities in which the borrower is obligated to repay the loan plus interest over a predetermined time frame.
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A key difference between notes and bonds is the time until maturity. Notes typically have short- to medium-terms ranging from two to 10 years, while bonds typically mature beyond 10 years, often in 20 or 30 years.
Notes can be secured or unsecured. A secured note is when an asset (usually tangible) serves as collateral for a loan. This could be anything from a car to a home. In real estate transactions, for example, a note is often secured by the property being financed. If the borrower defaults on the loan, the issuer of the note can liquidate the underlying collateral to recoup their loss.
In the case of a mortgage loan, as the borrower, you are obligated to fulfill the terms of your note until the property is fully paid off (plus interest) by maturity. If you default on your payments, the mortgage company can foreclose on your home to make back the lost money.
Alternatively, an unsecured note is not backed by any specific piece of collateral. This presents a higher risk to the lender because they may not be able to recoup their losses if the borrower defaults on payments.
Types of Notes in Finance
There are many notes investors need to be aware of. A few of the most commonly used are promissory notes, Treasury notes, municipal notes, mortgage notes, and convertible notes. Learn more about each of these below.
Promissory Notes
A promissory note is a type of note commonly used by companies to raise money. As with most types of debt, the lender—in this case, the investor—agrees to loan a certain amount of money to a company. In return, the company promises to pay the investor a fixed return on their investment, in addition to annual interest.
Structured Notes
Structured notes are securities issued by financial institutions, and the values are derived from an underlying asset, such as an equity index, commodity, or a basket of equity securities.
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An investor’s return on a structured note depends on how that asset performs. Examples of structured notes include principal-protected notes and reverse convertible notes.
Treasury Notes
T-notes are medium-term securities of two to 10 years issued by the U.S. Treasury. The funds raised often go toward funding public services and paying interest on the national debt. With this type of note, investors receive interest payments every six months until maturity.
Treasury notes can be a risk-free way to hedge risk in your investment portfolio. T-notes are backed by the “full faith and credit” of the U.S. government. This means you are guaranteed to make your money back, even during an economic recession. It’s also important to note that interest earned on T-notes may be exempt from state and local income taxes, and federal income taxes still apply.
Municipal Notes
A municipal note is a short-term debt instrument a state or local government issues to raise money, commonly for revenue shortfalls. Municipal notes are secured by sources that are expected to create revenue, such as tax receipts or bond proceeds. Since terms are extremely short—typically one year or less—the investor is typically paid the full interest at maturity.
Mortgage Notes
A mortgage note is technically a promissory note; however, it is associated with a mortgage loan. It is a written promise to fulfill the terms in your loan agreement, which outlines the amount you will repay plus interest and the repayment terms. Individuals can invest in mortgage notes by purchasing them on a secondary market.
Convertible Notes
Convertible notes typically apply during the early funding stages of a startup, as the new company will raise funds by selling convertible notes. Purchasers of convertible notes can exchange the note for equity in the company at a later date. In other words, a convertible note can later “convert” into stock ownership.
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Many angel investors use convertible notes when providing funding for a company that does not have a clear or direct valuation. This way, when an investor later buys shares in the company, the balance will automatically convert to equity.
What Notes Mean for Individual Investors
Lenders can sell notes in a secondary market for investors to purchase. Freddie Mac, for example, purchases qualified mortgage securities from lenders in the United States. The company then bundles various mortgage-backed securities and sells them to investors worldwide. Lenders use the proceeds from the loan sale to issue new mortgage loans. In turn, Freddie Mac uses the proceeds of that sale to make new loans for other homebuyers.
