How to Charge Interest on a Loan: AFR, Usury Caps, and Promissory Notes

When you lend money to a friend, relative, or anyone else privately, the interest rate you charge has to clear two hurdles: an IRS minimum and a state maximum. The IRS requires you to charge at least the Applicable Federal Rate (AFR) for the length of the loan, which ranges from 3.56% to 4.70% for February 2026.¹ Your state’s usury law caps how high you can go. Knowing how to charge interest on a personal loan means picking a rate between those two numbers, documenting it in a promissory note, and reporting the interest you collect each year.

The IRS Minimum: Applicable Federal Rate

Each month the IRS publishes three AFR tiers tied to the length of the loan. For February 2026, with annual compounding, the minimums are:¹

Short-term, under 3 years: 3.56%
Mid-term, 3 to 9 years: 3.86%
Long-term, over 9 years: 4.70%

The published rate shifts slightly if interest compounds semiannually, quarterly, or monthly rather than annually, so match the AFR tier to the compounding method you plan to use. The rates reset every month on the IRS Applicable Federal Rates page.² You can lock in the AFR published for the month you fund the loan, even if rates rise later.

One structural choice affects which rate governs. A term loan has a fixed maturity date, and the IRS measures it against the AFR in effect when you made the loan. A demand loan has no set repayment date and can be called in anytime; the IRS tests it against a floating AFR that resets each period.³ For most private loans, a term loan is simpler because the rate stays predictable.

What Happens If You Charge Less Than the AFR

Charge below the AFR and the IRS treats the shortfall as “forgone interest.” Under Section 7872, the agency effectively rewrites the deal: you’re treated as having received the full AFR-level interest (taxable income to you) and then having gifted the same amount back to the borrower.³ You owe income tax on money you never collected.

The gift side creates separate paperwork. If the imputed interest plus any other gifts you give that borrower in the calendar year exceeds $19,000, you have to file Form 709, the federal gift tax return. Filing doesn’t necessarily mean owing. The return reports the gift and subtracts it from your lifetime exemption, which is $15,000,000 for 2026.⁴ Few people actually pay gift tax, but the filing obligation catches lenders off guard.

Small-Loan Exceptions That Spare Most Family Lending

Two safe harbors in Section 7872 take most modest private loans out of the imputed-interest system entirely.

The first is the $10,000 de minimis rule. If total outstanding loans between you and the borrower never exceed $10,000, Section 7872 simply doesn’t apply, and you can charge zero interest. The exception vanishes if the borrower uses the money to buy or carry income-producing assets like stocks or rental property.³

The second applies to gift loans up to $100,000. For those, the amount of interest the IRS imputes is capped at the borrower’s actual net investment income for the year. If the borrower earned less than $1,000 of investment income, net investment income is treated as zero and no interest gets imputed at all.³ This exception falls away if total outstanding loans between the two of you cross $100,000, or if the IRS finds tax avoidance was a principal purpose of the arrangement.

State Usury Laws: The Ceiling

While the AFR sets the floor, state usury law sets the maximum. Every state caps interest for at least some kinds of loans, though the specific limits and which loans they cover vary widely. Rates that violate a usury cap can trigger forfeiture of all interest, civil fines, treble damages payable to the borrower, or in extreme cases a court declaring the loan void and unenforceable.

Many states exempt certain lending categories from their usury caps, including business and commercial loans, credit card debt, first-lien residential mortgages backed by federal agencies, and seller-financed purchases. A personal loan to a friend or family member is typically subject to the full state cap with no exemption. Look up your state’s limit for the type of loan you’re making before setting the rate. Even a fraction of a percent over the cap can cost you the right to collect any interest at all.

Reporting the Interest You Collect

Every dollar of interest you receive is reportable on your federal return, whether or not anyone sends you a Form 1099-INT.⁵ Private loan interest goes on your Form 1040, and if your total interest income for the year exceeds $1,500, you also need Schedule B.⁶

Your borrower generally isn’t required to send you a 1099-INT. The IRS instructions specifically exclude interest on obligations issued by individuals from the mandatory 1099-INT filing rules.⁷ Track interest payments carefully on your own anyway. The IRS can match a borrower’s claimed interest deduction against your reported income, and a mismatch invites questions.

One special case: if you’re making a private mortgage secured by the borrower’s home and they plan to deduct the mortgage interest, Schedule B specifically requires you to report that seller-financed mortgage interest along with the borrower’s name and address.⁶

Writing the Promissory Note

A promissory note is what turns a handshake into an enforceable obligation. Without one, collecting on a defaulted loan becomes a credibility contest in court. A workable note includes:

Full legal names and addresses of both lender and borrower.
Principal amount in both figures and words. Writing out the dollar amount prevents alteration.
Interest rate and calculation method, confirming the rate meets or exceeds the current AFR and stays within your state’s usury limit.
Payment schedule, specifying frequency and the exact due date for each payment.
Maturity date when all remaining principal and interest must be paid.
Late fee provision, stating the amount or percentage charged for overdue payments and the grace period before it applies. Keep the fee reasonable. Courts in many states refuse to enforce a late charge that looks like a penalty rather than compensation for the inconvenience.

Templates from legal document services work fine, but every template needs customization. Plug in the correct AFR for the month you fund the loan, confirm your state’s usury cap, and make sure the payment schedule matches what both sides actually agreed to.

Spell out whether interest is simple or compound. Simple interest is calculated only on the original principal and stays flat; a $10,000 loan at 5% simple interest for three years produces $1,500 in interest, period. Compound interest charges interest on principal plus any accrued but unpaid interest, so the balance grows faster. The AFR is published for annual, semiannual, quarterly, and monthly compounding, so the minimum rate you must charge depends on which method you choose.¹ Disputes about how interest accrues are common in private lending and entirely preventable with a clear sentence in the note.

Securing the Loan With Collateral

An unsecured note gives you a legal claim, but if the borrower defaults and has no assets, the claim is worth very little. A security interest in specific property gives you priority over other creditors and a route to recover your money.

For personal property like a vehicle, equipment, or financial account, you need a written security agreement signed by the borrower that grants you an interest and describes the collateral clearly enough to identify it. To protect that claim against third parties, file a UCC-1 financing statement with the secretary of state. Filing is what gives the interest “perfection,” meaning other creditors and buyers are on notice. Without perfection, your security interest may be good between you and the borrower but worthless against anyone else.

For real property, the loan is secured by a mortgage or deed of trust recorded with the county where the property sits. Recording fees vary. If the borrower plans to deduct the mortgage interest, the security instrument must be properly recorded under state law; cutting corners costs the borrower that deduction.⁸

Default and Acceleration Clauses

Without a default provision, you’re chasing missed payments one at a time. An acceleration clause makes the entire remaining balance due immediately if the borrower breaks a material term, most commonly by missing payments.

When you accelerate, the borrower owes unpaid principal plus interest accrued through that date. They do not owe the interest that would have accumulated over the rest of the loan had they kept paying on schedule. The clause should define exactly what counts as default (a specific number of missed or late payments is the most common trigger), whether you must give written notice and a chance to cure before accelerating, and how notice must be delivered. Courts enforce acceleration more readily when the clause includes a reasonable cure period than when it allows immediate acceleration with no warning.

Signing and Funding

Both parties sign the completed note. Electronic signatures carry the same legal weight as ink signatures for transactions in interstate commerce, so a secure e-signature platform is valid.⁹ Having a notary public witness the signing adds protection against later claims of forgery or confusion. Notary fees are set by state law and typically run under $15 per signature.

Fund the loan through a traceable method: wire transfer, cashier’s check, or direct bank transfer. Personal checks work but take time to clear and can bounce. The paper trail matters more than most lenders expect. If the borrower later claims they never got the money, your bank record ends the argument fast. Keep the original signed note, the funding receipt, and the amortization or payment schedule in a secure place, whether a fireproof safe or an encrypted digital backup. You’ll need those records every tax year the loan is outstanding, and potentially for years afterward if it’s ever disputed.

1
Internal Revenue Service. Revenue Ruling 2026-3: Applicable Federal Rates for February 2026
2
Internal Revenue Service. Applicable Federal Rates
3
Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
4
Internal Revenue Service. What’s New – Estate and Gift Tax
5
Internal Revenue Service. Topic No. 403, Interest Received
6
Internal Revenue Service. About Schedule B (Form 1040), Interest and Ordinary Dividends
7
Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID
8
Internal Revenue Service. Publication 936, Home Mortgage Interest Deduction
9
Office of the Law Revision Counsel. 15 USC 7001 – General Rule of Validity