The interest rate on a promissory note has to sit inside a window with two walls: the IRS sets the floor through its monthly Applicable Federal Rates, and your state’s usury law sets the ceiling. For 2026, the federal floor runs from about 3.59% on short-term loans up to 4.72% on long-term ones. State ceilings for private personal loans typically fall between 6% and 18%. Pick a rate below the floor and you owe tax on interest you never collected; pick one above the ceiling and you can lose the right to collect any interest at all.
The IRS Floor: Applicable Federal Rates
Every month the IRS publishes Applicable Federal Rates under Internal Revenue Code Section 1274(d). These are the minimum rates a private lender should charge to keep the IRS from treating the loan as a below-market transaction.1Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property The rate you use depends on the length of the note:
- Short-term, three years or less: 3.59% annually in early 2026
- Mid-term, over three years but not over nine: 3.82% to 3.93%
- Long-term, over nine years: 4.72%
The numbers move each month with market conditions, and the rate that governs your note is the one published for the month you make the loan.2Internal Revenue Service. Revenue Ruling 2026-06 – Applicable Federal Rates for March 2026 Lock the rate in the note itself so there is no argument later about which month applied.
What Happens If You Charge Less Than the AFR
When a note charges below the AFR, Section 7872 treats the difference as “forgone interest.” The IRS pretends the lender received that interest and taxes it as ordinary income, which can hit 37% at the top bracket. The lender writes a check to the IRS for money that never actually came in.3Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
On a family loan the damage doubles. The forgone interest is also treated as a gift from lender to borrower. If gifts to one person exceed the 2026 annual exclusion of $19,000, the lender has to file Form 709.4Internal Revenue Service. What’s New – Estate and Gift Tax Gifts past the lifetime exemption can face a federal gift tax rate up to 40%.5Internal Revenue Service. Instructions for Form 709 A parent who lends a child $200,000 interest-free isn’t just being generous in the eyes of the IRS; the parent has imputed income to report and, likely, a gift tax return to file.
Small-Loan Exceptions
Two carve-outs soften this for smaller amounts. If total loans between two individuals stay at or below $10,000, Section 7872 doesn’t apply at all. Zero interest is fine. The exception disappears if the borrower uses the money to buy income-producing assets like stocks or a rental property.3Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
For gift loans between individuals up to $100,000, the imputed interest is capped at the borrower’s net investment income for the year. If the borrower earned $500 in dividends and interest, that’s the ceiling on what the IRS can impute to you. If the borrower’s net investment income is $1,000 or less, it’s treated as zero. This exception disappears if tax avoidance is a principal purpose of the loan, and it vanishes entirely once outstanding balances between the two people cross $100,000.
The State Ceiling: Usury Limits
Every state caps interest on private loans, but the caps vary. Personal-loan ceilings generally sit between 6% and 18%, and many states allow higher limits for credit cards, auto loans, or commercial credit. Some tie the cap to a moving benchmark like the Federal Reserve discount rate rather than a flat percentage.
A written agreement can change the ceiling. Several states let the parties agree in writing to a rate above the default statutory cap; the statutory number applies only when the contract is silent. Don’t assume the general cap is a hard maximum without checking how your state treats written agreements.
The penalties for going over are steep and vary by state:
- Loss of the right to collect any interest, sometimes including interest already paid
- In some states, the entire loan becomes unenforceable and the lender cannot recover principal either
- Double or triple damages on usurious interest collected
- Criminal charges at extreme rates, ranging from misdemeanor to felony depending on the jurisdiction
A rate that reads as reasonable in one state can be illegal in the next. Check your state’s specific limit before you finalize the note.
Why Bank Rates Aren’t the Benchmark
Nationally chartered banks can charge the maximum rate allowed by the state where the bank is located, even when they lend into states with lower caps. This “exportation” rule under 12 USC 85 is why a credit card issuer can charge 29.99% into a state that caps personal loans at 10%.6Office of the Law Revision Counsel. 12 USC 85 – Rate of Interest on Loans, Discounts and Purchases The preemption extends to federally chartered savings associations and FDIC-insured state banks. It does not extend to private promissory notes between individuals or non-bank entities. Your state’s cap applies in full.
Fixed or Variable
A fixed rate stays put for the life of the note. Both sides know every payment amount in advance. For most private notes, especially shorter ones, fixed is the sensible default.
A variable rate floats with a published index, commonly the Prime Rate or the Secured Overnight Financing Rate (SOFR), plus a stated margin such as “SOFR plus 2%.”7Freddie Mac. SOFR-Indexed ARMs If you go variable, spell out the exact index, how often the rate resets, and a ceiling on how high it can climb. A variable rate without a cap can drift above your state’s usury limit during a market spike and expose the lender to penalties.
Simple or Compound
The rate is only half of what determines the dollars. The other half is the calculation method.
Simple interest charges only on the original principal. A $50,000 note at 5% simple interest for three years produces $2,500 a year and $7,500 total. This is the standard method for private notes.
Compound interest adds unpaid interest back to the principal so future interest accrues on prior interest. The same $50,000 at 5% compounded annually generates $7,881.25 over three years. The gap widens sharply on longer notes and with monthly or daily compounding.
Day-count convention matters too. A 360-day year divides the annual rate by 360 and multiplies by the actual days elapsed, which slightly increases the effective yield versus a 365-day calculation. Commercial loans often use 360 days; consumer loans usually use 365. Whichever you choose, put it in the note.
Default Rate Bump
Most promissory notes raise the interest rate if the borrower defaults, typically by 2% to 5% above the regular rate. The bump compensates the lender for added risk and gives the borrower reason to stay current.
Two limits apply. First, the default rate still has to sit below your state’s usury cap. A note at 8% that jumps to 18% may be lawful in one state and usurious in another. Second, courts look at whether the higher rate reasonably estimates the lender’s damages or functions as an unenforceable penalty. A few extra points usually holds up. A rate that triples on default invites a challenge that can void the increase.
Making the Note Hold Up as a Loan
The tax treatment of everything above assumes the IRS accepts that you actually made a loan. If it reclassifies the note as a disguised gift, the entire principal becomes a taxable transfer, not just the forgone interest. The agency looks at whether you genuinely intended a loan at the time of the transaction.8Internal Revenue Service. Topic No. 453, Bad Debt Deduction
Build the paper trail a bank would build:
- A written promissory note with the principal, an interest rate at or above the AFR, a repayment schedule, a maturity date, and default terms
- Actual payments made on schedule; a pattern of skipped payments followed by forgiveness looks like a gift
- Documented collection efforts if the borrower stops paying
- Arm’s-length terms that resemble what a commercial lender would offer for a similar loan
Good documentation also preserves a nonbusiness bad debt deduction if the borrower truly can’t repay. Without it, that deduction goes away along with the loan characterization.