What happens if a promissory note does not state an interest rate?

If a promissory note does not state an interest rate, the borrower generally owes no interest while the loan is current. Once the note is past due, state law usually adds interest at a statutory rate, such as 9% in New York, 10% in California, or 5% in Illinois.

Does a promissory note without an interest rate charge interest?

No. The Uniform Commercial Code answers this directly. In North Carolina's version, G.S. 25-3-112(a) says that unless the note provides otherwise, "an instrument is not payable with interest." This is the standard UCC rule.

The same section adds a rule for notes that do bear interest. Unless the note says otherwise, interest on an interest-bearing note is payable from the date of the note.

So a note that says "I promise to pay $10,000 on June 1" and nothing more is an interest-free loan. The borrower repays $10,000, and the lender cannot add interest for the time before the due date.

A zero-interest note is still a binding note. The loan itself supports the borrower's promise. Interest-free notes are common for demand loans between family members and for short unsecured loans between friends.

What if the note promises interest but gives no rate?

That is a different problem with a different answer. Under G.S. 25-3-112(b), if a note provides for interest but the amount cannot be figured from its description, interest is payable at the judgment rate in effect at the place of payment when interest first accrues.

In other words, the law will not let the promise of interest go to waste, but it will choose the rate for you. That rate may be far lower, or higher, than what you had in mind.

What interest applies after a note with no rate defaults?

State law fills the gap once the borrower misses the due date. The rules differ by state.

In New York, CPLR 5001(a) says interest shall be recovered on a sum awarded for breach of a contract, computed from the earliest date the claim existed. CPLR 5004 sets the rate at 9% a year. For a consumer debt where a natural person is the defendant, CPLR 5004 sets the rate at two percent.

In California, Civil Code 3289(b) says that if a contract does not stipulate a legal rate of interest, the obligation bears interest at 10% per year after a breach. That subsection does not apply to a note secured by a deed of trust on real property.

In Illinois, 815 ILCS 205/2 allows creditors to receive 5% per year on money after it becomes due on a promissory note.

In North Carolina, G.S. 24-5(a) says an award on a contract bears interest from the date of breach, and G.S. 24-1 sets the legal rate at eight percent.

The gap between these rates adds up. Take a $10,000 note with no stated rate that goes unpaid for six months after its due date. At 10% in California, six months of interest is $500, since $10,000 times 10% times half a year equals $500. At 9% in New York, it is $450, or $100 at the two percent consumer debt rate. At 5% in Illinois, it is $250. In each case, the interest runs only from the default.

These statutory rates are a backstop. They often run lower than the rate you could have written into the note, and you may need a court case to collect them.

What does the IRS say about interest-free loans?

Federal tax law can treat an interest-free loan as if it charged interest. The rule is 26 U.S.C. 7872, which covers below-market loans, including gift loans between individuals. The Internal Revenue Service (IRS) publishes the applicable federal rates used to measure the forgone interest each month.

There are two important breaks for family loans. Under section 7872(c)(2), the rule does not apply to a gift loan between individuals on any day the total outstanding loans between them are $10,000 or less, unless the loan is used to buy or carry income-producing assets. Under section 7872(d)(1), for gift loans totaling $100,000 or less, the interest treated as paid back to the lender each year cannot exceed the borrower's net investment income. If that income is $1,000 or less, it is treated as zero. This limit does not apply if tax avoidance is one of the principal purposes of the arrangement.

Here is how that works. A $9,000 interest-free loan to your sister is under $10,000, so section 7872 generally does not apply. A $150,000 interest-free loan to your son is over $100,000, so the net investment income limit does not help, and you may need to report imputed interest. Talk to a tax professional before you make a large loan with no interest.

How do you add an interest rate to an existing note?

Use a written amendment signed by both the lender and the borrower. The amendment should identify the original note by date and amount, state the new rate, and say when interest starts to accrue. In most cases, interest should start on the amendment date and not before.

Give the borrower something in exchange, such as a longer repayment period or a lower monthly payment, so the change is supported by new consideration. Update the payment schedule so it reflects the new interest, and keep the signed amendment with the original note. If the original note was payable on demand, the amendment can also set fixed payment dates, which turns it into an installment note with a clear due date for each payment. That makes any later default easier to prove.

Make sure the new rate fits your state's limit. Our usury limit checker lets you compare a proposed rate with the cap in your state.

Should you state a rate from the start?

Yes, in most cases. Even if you want an interest-free loan, say so in the note with a line such as "This note bears no interest before maturity." Then add a separate rate that applies after default, within the usury limit. A clear rate avoids a dispute over which statute applies and makes the borrower's cost of paying late easy to calculate.

Sources

• N.C. G.S. 25-3-112
• N.Y. CPLR 5001
• N.Y. CPLR 5004
• California Civil Code 3289
• 815 ILCS 205/2
• N.C. G.S. 24-5
• 26 U.S.C. 7872
• IRS applicable federal rates