What interest rate should I put on a promissory note?

Something between two legal lines. The floor, for family loans over $10,000, is the IRS applicable federal rate for the loan's term, published monthly. The ceiling is your state's maximum legal rate. Between them, most private lenders pick a rate near what the money would earn elsewhere or near what the borrower would pay a bank, and write it as a fixed annual percentage.

Can I lend money with no interest?

Yes. A zero-interest loan is legal. For loans between individuals of $10,000 or less, the IRS below-market loan rules generally do not apply, as long as the money is not used to buy income-producing assets. Above that, an interest-free loan can create imputed interest, meaning the lender may owe tax on interest they never collected and the forgone interest can count as a gift.

What is the maximum interest rate on a private loan?

It depends on the state. Each state sets its own usury limit, and many have different caps for written agreements, consumer loans, and business loans, plus exemptions. A handful of states have no general cap on loans between individuals. Charging above the limit can void the interest or the whole loan in some states, so check your state before you pick a rate.

Should the rate be fixed or variable?

Fixed, for almost every private loan. A fixed rate is simple to calculate, easy for both sides to understand, and hard to dispute. A variable rate needs a named index, a margin, adjustment dates, and caps, which is more drafting than most family or friend loans justify.

Do late fees and default interest count toward the usury limit?

Often they do. Many states treat default interest, and in some cases fees, as interest for usury purposes. A note with a legal base rate and a steep default rate can end up over the cap once the borrower misses payments. Keep the default rate well under your state limit.

Choosing the interest rate on a promissory note: the floor, the ceiling, and what is fair

The rate is the one blank on a promissory note that people fill in by feel. Five percent sounds reasonable, so it goes in. It usually works out, but there are two legal lines the number has to sit between, and each one has its own penalty for getting it wrong.

The floor: the IRS applicable federal rate

The IRS publishes applicable federal rates every month, with separate rates for short-term (up to 3 years), mid-term (over 3 and up to 9 years), and long-term loans. For loans between individuals, charging less than the AFR on a loan over $10,000 can trigger imputed interest: the lender may owe tax on interest they never received, and the forgone interest can count as a gift. Loans of $10,000 or less generally fall outside these rules, and a larger exception applies up to $100,000 when the borrower's investment income is small. Use the rate for the month the loan is made. See imputed interest and the AFR.

The AFR only matters for tax purposes. A below-AFR loan is still a valid loan. It just may cost the lender at tax time.

The ceiling: your state usury limit

Every state sets its own maximum legal interest rate, and the numbers vary a lot. Many states have different caps for written and oral agreements, consumer and business loans, and a list of exemptions. A few states have no general cap on loans between individuals. Going over the limit can mean losing the interest, paying penalties, or in some states having the whole loan voided. Look yours up with the usury limit checker or the maximum legal interest rate by state. If the borrower lives in another state, check which law governs; see charging interest across state lines.

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Picking a number between the lines

Most private lenders anchor on one of three reference points:

What the money would earn otherwise. A savings account or CD rate means the lender gives up nothing by lending.
What the borrower would pay a bank. A rate below that gives the borrower a real benefit and keeps the loan fair to both.
The risk. An unsecured loan to someone with a shaky payment history justifies a higher rate than a loan secured by a car or a house.

For family loans, a rate at or slightly above the AFR is common because it satisfies the IRS and stays generous. For business loans, rates are usually higher and the usury rules are often looser; see promissory notes for business loans.

Default interest counts too

Many notes add a higher default rate once the borrower is late. Many states count default interest, and sometimes fees, toward the usury cap. A note with a 7 percent rate and an aggressive default rate can cross the line the moment the borrower misses a payment. Keep the default rate comfortably under the cap. See late fees and default interest.

Writing the rate so it can't be misread

State it as an annual percentage: "six percent (6%) per year."
Make the words and the numerals match. When they conflict, the words usually control. See mistakes in a signed note.
Say simple interest or compound, and how often it accrues. Simple interest is the norm for private notes. See how to calculate interest.
Say fixed. A variable rate needs an index, margin, adjustment dates, and caps.
Date the note so the AFR month is clear.

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