Promissory notes are a type of loan

Promissory Notes and Interest

When people think of financing a venture, for either business or personal reasons, they normally think of going to the bank. And although banks are, by far, the primary lending source for most people and businesses, banks don't have a monopoly on lending. The promissory note is a legitimate alternative that can make anyone a lender. Promissory notes lie somewhere between the informality of an IOU and the rigidity of a loan contract in terms of their legal enforceability.

There are four major factors that make up the terms of a promissory note: the amount of the loan, the interest rate, the repayment schedule and the consequences of default. Notes are usually repaid in monthly installments or as a lump sum payment at the end of a specified time period. If the borrower defaults on the terms of payment, there can be consequences such an acceleration clause, which requires the borrower to immediately pay the loan in full.

Setting Interest Rates

The lender must charge an interest rate that reflects fair market value. Interest rates are governed by state usury laws, which limit the amount of interest that can be charged. Setting interest rates that are above the state-mandated limits are not enforceable in a court of law. Lenders who set interest rates that are too far above the usury limit can, in some cases, be legally punished. Also, be aware that if the interest rate is too low it can cause the IRS to consider the loan a gift, causing negative tax implications.

The interest rate on a loan in often contingent upon several factors like the loan amount, terms and collateral. When an agreement is made, the promissory note states your loan terms. As long as the terms of the agreement are not violated, the rate can’t be any higher than what was quoted in the promissory note.

Calculating Interest

When you know the principal amount, the interest rate and the length of the loan (time), the amount of interest incurred for the life of the loan can be calculated by using the formula: Interest = Principle * Rate * Time

For example, a loan of $10,000 with an interest rate of 8.5% for a 5 year period, will generate $4,250 in interest.

Last Updated: February 16, 2015