Definition and Examples of Notes in Finance
How do notes work in finance?
Types of notes in finance
What do notes mean for individual investors?
Definition and Examples of Notes in Finance
A note is a short to medium-term debt instrument expected to be repaid by the borrower, along with interest. Notes typically have a specified time frame within which repayment must occur. Common examples of notes include treasury notes, promissory notes, and mortgage notes.
How do notes work in finance?
As mentioned, a note acts as a promise from the borrower to repay the debt plus interest, usually within a specified timeframe. Notes function similarly to bonds. Both are types of debt securities where the borrower commits to repaying the loan along with interest over a predetermined period.
A key difference between notes and bonds is the time until maturity. Notes are typically for short to medium terms, ranging from two to ten years, while bonds generally mature after more than ten 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 the loan. This can be anything from a car to a house. In real estate transactions, for example, the note is typically secured by the financed property. If the borrower defaults on the loan, the issuer of the note can foreclose on the collateral to recover losses.
In the case of a mortgage loan, as a borrower, you are obligated to meet the terms of your note until the property is fully paid off (along with interest) by the maturity date. If you default, the mortgage company can seize your home to recoup lost funds.
Conversely, an unsecured note is not backed by any specific piece of collateral. This poses a higher risk to the lender, as they may not be able to recover their losses if the borrower defaults.
Types of Notes in Finance
There are several types of notes that investors should be aware of. Some of the most commonly used include promissory notes, treasury notes, municipal notes, mortgage notes, and convertible notes. Learn more about each of them below.
Promissory Notes
A promissory note is a type of note typically used by companies to raise money. As with most types of debt, the lender – in this case, the investor – agrees to lend a specific amount of money to the company. In return, the company promises to pay a fixed return on their investment, plus annual interest.
Structured Notes
Structured notes are securities issued by financial institutions, and they derive their value from an underlying asset, such as a stock index, commodity, or a basket of securities. The return to investors depends on the performance of this asset. Examples of structured notes include capital-protected notes and reverse convertible notes.
Treasury Notes
Treasury notes are medium-term securities ranging from two to ten years issued by the U.S. Department of the Treasury. The funds raised are typically used to finance public services and pay interest on national debt. With this type of note, investors receive interest payments every six months until maturity dates.
Treasury notes can be a risk-free way to hedge risks in your investment portfolio. Treasury notes are backed by the “full faith and credit” of the U.S. government. This means it guarantees the return of your funds, even during an economic recession. It is also important to note that the interest earned on treasury notes may be exempt from state and local income taxes, but federal taxes still apply.
Municipal Notes
A municipal note is a short-term debt instrument issued by a local or state government to raise funds, usually to cover revenue shortfalls. Municipal notes are secured by sources expected to generate revenue, such as tax receipts or bond revenues. Because the term is very short – typically a year or less – full interest is paid to investors at maturity dates.
Mortgage Notes
Mortgage
The mortgage note is practically a promissory note, but it is tied to a mortgage loan. It is a written promise to comply with the terms specified in your loan agreement, which outlines the amount you will repay along with interest and the repayment terms. Individuals can invest in mortgage notes by purchasing them in the secondary market.
Convertible Notes
Convertible notes typically apply in the early financing stages of a startup, where the new company raises funds by selling convertible notes. Buyers of convertible notes can later convert the note into equity in the company. In other words, the convertible note can later turn into equity.
Many angel investors use convertible notes when providing funding to a company that does not have a clear or direct valuation. This way, when the investor later buys shares in the company, the balance will automatically convert to equity.
What Do Notes Mean for Individual Investors?
Creditors can sell notes in the secondary market to be purchased by investors. For example, Freddie Mac buys eligible mortgage-backed securities from creditors in the United States. The company then aggregates various mortgage-backed securities and sells them to investors worldwide. Creditors use the proceeds from loan sales to issue new loans. In turn, Freddie Mac uses the proceeds from those sales to issue new loans to potential homebuyers.
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Sources:
FINRA. “Bond Glossary.” Accessed Sept. 8, 2021.
U.S. Department of the Treasury Bureau of the Fiscal Service, TreasuryDirect. “Treasury Securities & Programs.” Accessed Sept. 8, 2021.
U.S. Department of the Treasury Bureau of the Fiscal Service, TreasuryDirect. “Learn More About Security Types.” Accessed Sept. 8, 2021.
U.S. Securities and Exchange Commission. “Treasury Securities.” Accessed Sep. 8, 2021.
Congressional Research Service. “Tax-Exempt Bonds: A Description of State and Local Government Debt.” Page 4. Accessed Sept. 8, 2021.
Source: https://www.thebalancemoney.com/what-is-a-note-5200566
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