How to Compute the Interest of an Interest Bearing Promissory Note

Whether you're shopping around for a simple interest promissory note or a discount promissory note, the calculation of interest remains the same. However, the two types of notes differ in how they handle interest. For a simple interest promissory note, you pay interest on the loan upon maturity. For a discount promissory note, you pay interest at the commencement of the loan by receiving a note discounted from its face value.

Calculating Interest

Step 1: Compute the Term Length

Count the number of days between the issuance of the promissory note and its maturity to calculate its term length. For example, if a note spans August 15 through November 13, there are 90 days in its term.

Step 2: Calculate the Fraction of a Year

Divide the number of days by 360 to convert the term into a fraction of a year. This fraction might be less than or greater than one year, depending on the term length. In the example, divide 90 by 360 to calculate 0.25 of one year.

Tip

Using 360 as the number of days is the Banker's Rule, but some lenders use the actual number of 365 days in a year instead. Therefore, ask your lender which method it employs when calculating interest.

Step 3: Calculate Term Interest Rate

Multiply the fraction of a year by the annual simple interest rate to calculate the term interest rate. Continuing with the example, if the annual interest rate was 10 percent, multiply 0.25 years by the 0.10 annual rate to get a term rate of 0.025.

Step 4: Calculate the Interest

Multiply the term rate by the note's face value to calculate the interest. If the example's face value was $20,000 multiply 0.025 by $20,000 to get the simple interest of $500.

Tip

For a simple interest promissory note, the interest plus the face value is the amount you need to repay on the maturity date. In the example, add $20,000 plus $500 to get the total due of $20,500.

For a discount promissory note, subtract the interest (discount) from the face value to arrive at the proceeds, which is the loan amount you actually receive. In the example, subtract $500 from $20,000 to get the proceeds of $19,500. However, you need to repay the full $20,000 at maturity. To calculate the effective rate in this case, divide the interest by the proceeds, multiplied by the faction of a year. In the example, multiply $19,500 by 0.25 to get 4,875. Divide the result into $500 to calculate the effective rate of 0.1026, or 10.26 percent, which is effectively higher than the actual interest rate. In fact, if the interest rate is the same, a discount promissory note will always be a worse deal than a simple interest promissory note.