How to Set Interest Rates on a Promissory Note

Selecting an interest rate for a promissory note can be a challenge. If the rate's too low, the lender may decide the interest income the note earns isn’t worth the risk. If the rate's too high, the borrower may refuse to accept the terms. If an agreement on the interest rate can’t be reached, both parties may be able to settle on a monthly payment amount that satisfies their interest rate requirements.

Step 1

Go online and find out the maximum interest rate a lender can charge in your state. You can find the information on your state’s website or on Usury Law, which lists each state’s interest rate cap. Check to determine that the interest rate you have in mind is under your state’s usury limit. If you're the borrower, verify the interest rate for yourself. Interest rates above the legal maximum limit are considered usury and are unenforceable in court.

Step 2

Use an online financial news source like the Wall Street Journal or Fed Prime Rate to find the current prime interest rate. Now find the current interest rate your local banks change for loans similar to yours. A reasonable rate is somewhere between the prime rate and the bank rate. For example, if the prime rate is 3.75 percent and the bank loan rate is 11 percent, you could use the borrower’s credit rating to determine how near or far from the 11 percent you should set the rate. The rate you both agree upon must not violate state usury laws.

Step 3

Determine the interest rate based on the agreed-upon payment amount. Find the principal amount of the loan as stated in the promissory note. Use a free online amortization calculator to calculate the amount of monthly interest. Divide the monthly interest amount by the principal loan amount to get the monthly interest rate.

Step 4

Looking at an example, if the monthly interest payment is $800 and the loan amount is $150,000, divide $800 by $150,000 to get the monthly interest amount, which is 0.0053. Convert 0.0053 to a percentage by multiplying it by 100, which is 0.53 percent per month. Now multiply the 0.53 percent by 12 months, to arrive at the annual interest rate, which is 6.4 percent. Decide if the interest rate needs to be adjusted or if it's acceptable to both parties as is.

Tip

  • Although it’s tempting to charge the highest possible interest rate, keep the payments affordable for the borrower to help eliminate the chance of default.

Warning

  • If you set the interest rate too low, the IRS can consider the loan a gift, which could have negative tax implications for both parties.

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