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Understanding Promissory Notes and Interest Rate

Understanding Promissory Notes and Interest Rate

Financing is a major issue for most businesses, especially during the startup phase. Loans from banks—or even from friends or family members—are a common financing device. If your business does need to borrow money, however, it is essential to properly document the loan through a promissory note.

In its simplest form, a promissory note is a written declaration, signed by the borrower, acknowledging an obligation to repay the lender the amount of the loan plus a specified amount of interest. A promissory note is therefore a written contract that the borrower may enforce through a court judgment if necessary. A properly executed promissory note is also considered a negotiable instrument under New York law, meaning the borrower can sell or assign the note to another person.

If you take out a loan from a bank or other commercial lender, they will provide long, detailed promissory note forms for you to sign. But even if you are simply borrowing money from a friend or relative, you should still have a written note drafted with the assistance of a qualified New York business or contracts attorney. A well drafted promissory note protects both the borrower and lender, as it helps avoid future misunderstandings over the precise terms of the loan.

Promissory Notes, Interest, and Usury

A promissory note must specify the percentage interest charged on the loan. All loans should carry some interest, even if it is between family members. The Internal Revenue Service establishes a minimum interest rate—known as the applicable federal rate—that a borrower must charge to avoid having the loan classified as a taxable gift.

On the other end of the spectrum, New York law also caps the maximum amount of interest a borrower may charge on a promissory note. Historically, interest of any kind on a loan was declared illegal under what are known as usury laws. Today, usury refers to state-imposed limits on interest rates.

New York law defines usury as any loan made at a rate of more than 16 percent interest. Any loan made in excess of this limit is considered null, void, and unenforceable in New York courts. In addition, a borrower who charges more than 25 percent interest is guilty of a Class E felony, conviction of which may result in multiple years imprisonment.

It should be noted that while usury is generally defined by state law, the federal government may also punish usury as a form of racketeering. The federal RICO act prohibits the collection of “unlawful debts,” which include any loan where the specified interest rate is twice the applicable legal limit. So in this case of a New York loan, an interest rate of 32 percent might trigger a federal prosecution.

Keeping Your Loans Legal

Whether you are a borrower or a lender, anytime you participate in a private loan, you should only do so through a written promissory note reviewed by a competent business attorney. Contact our office today if you have any questions on this or any other business legal matter.

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