A promissory note is a contract between two parties by which one party, the borrower, agrees to repay another party, the lender, the amount of the loan, along with a specified interest rate. As legally-binding contracts, promissory notes may be brought before a court for enforcement via a judgment.
Are Interest Rates Required for Promissory Notes?
Every promissory note should specify the interest rate charged on the loan, regardless of the relationship between the parties. Interest rates are required because in the eyes of the Internal Revenue Service (the “IRS”), there is no such thing as a zero-interest loan. The corresponding interest rate for every loan must be higher that the IRS’s Applicable Federal Rate (the “AFR”). If the interest rate is lower than the AFR, then the difference between the AFR and the loan’s interest rate must be reported to the IRS as taxable income.
Importantly, the AFR is not a constant figure, but is instead a percentage that is calculated every month by the IRS and published on their website. The IRS provides AFRs for short, mid-, and long-term loans, as well as for loans compounded annually, semiannually, quarterly, and monthly. For example, the AFRs for short-term loans compounded annually for January, February, and March 2023 have been: 4.50%, 4.47%, and 4.50%, respectively. Therefore, if an individual were to execute a promissory note in March 2023, on a $20,000 loan with a 1% interest rate, the imputed interest will be $700. This can be calculated by subtracting the difference between what the loan’s total interest would be under the current AFR ($900) and the loan’s interest rate under the promissory note ($200). As such, the $700 difference would have to be reported to the IRS. To avoid this issue, it is strongly recommended that all individuals executing promissory notes incorporate interest rates at a level equal to or higher than the AFR for the month the note is executed.
What are the Limitations on Interest Rates?
Much like how it is strongly recommended to incorporate interest rates equal to or above the AFR, it is illegal to charge interest rates higher than those specified by a state’s usury laws. Usury is the practice of attaching unreasonably high interest rates to loans. As such, usury laws prevent this conduct by capping the interest rate depending on the amount of the loan. In Florida, a contract will be deemed “usurious” if it attaches an interest rate higher than 18% on any loan or obligation for $500,000 or less. Therefore, if a lender charges a rate higher than 18% on any loan that does not exceed $500,000, they could be subject to civil penalties, including forfeiture of the entire interest amount due under the loan.