How to Calculate Interest on a Promissory Note

A promissory note is an integral element of the modern loan process used by banks and financial institutions. The note is a legally recognized instrument that obliges one party (the borrower) to pay a specific sum of money to another party (the lender). Details relevant to the length of repayment, the specific payment installments that must be made and the amount of interest accruing on the money over time are found within the promissory note. This information, combined with simple mathematical formulas, is all you need calculate interest payments on a daily, monthly or annual time frame.

TL;DR (Too Long; Didn't Read)

There is no singular promissory note formula that can help you determine how to calculate interest. Your interest rate calculations will be based on whether the promissory note includes simple interest or compounding interest.

The Basics of Interest Accrual

The process of dividing a loan into recurring principal and interest payments is commonly referred to as amortization. When a borrower agrees to an amortized loan, they are accepting a payment scheme in which their recurring monthly payments will be used to pay off both principal and interest on their loan simultaneously, albeit in varying proportions throughout the life cycle of the loan.

Amortized loans fall into two specific categories: fully amortized and partially amortized. These two payment schemes are distinguished from one another by how they approach the repayment of principal. With a fully amortized loan, the borrower will have fully repaid the principal and interest on the loan by the time the payment schedule is completed using only the dictated monthly payments. This differs greatly from a partially amortized loan, however, which relies on a final "balloon payment" to cover the remaining principal balance.

Generally speaking, loans such as home mortgages commonly fall into the category of fully amortized loans. However, there are always exceptions to this rule, and it is quite possible for a mortgage applicant to be presented with a partially amortized loan option.

Promissory Note Interest Types

Individuals choosing to pursue a partially amortized loan can expect for their interest payments to be equal or lower than a fully amortized loan. The appeal of these loans for borrowers is the reduced monthly payments, even though the large balloon payment is looming at the end of the repayment schedule.

Irrespective of whether a loan is fully or partially amortized, what can also affect the amount of money owed in interest is whether the interest is classed as compounding interest or simple interest. When interest compounds, it is added back into the principal balance of the loan. Because of this, even a fixed interest rate will generate increasingly larger sums of interest over time. This differs from simple interest, in which the total sum of interest owed can be determined by taking the daily interest rate and multiplying it by the length of loan repayment.

Calculate Interest Due

To calculate the interest on your promissory note, you will not need to use an amortization calculator. If the interest is classified as simple interest, first take your annual interest rate in percentage form and divide it by 365 to obtain your daily interest rate. Then multiply the decimal formatted version of this percentage (which can be obtained by dividing the percentage value by 100) by the principal balance in order to determine the total amount of interest accruing on a daily basis.

If interest compounds annually, you will need to calculate the amount of interest generated in a year using the steps outlined previously, and then add this sum back onto the principal balance before calculating the interest for the second year. You must repeat this process throughout the life cycle of the loan.

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