Notes payable is a valuable financial tool that business owners can use to expand their business, and they can also serve as an investment option. Learn what notes payables entail, how to utilize them for investing or for your business.
Definition and Example of Notes Payable
Notes payable is a liability that arises when a business borrows money and signs a written agreement with a lender to pay back the borrowed amount of money with interest at a certain date in the future.
Alternative name: Promissory notes
These agreements often come with varying timeframes, such as less than 12 months or five years. Notes payable payment periods can be classified into short-term and long-term. Short-term notes payable are due within one year. Long-term notes payable come to maturity longer than one year but usually within five years or less. Notes payables, a form of debt, are typically securities and they must be registered with the Securities and Exchange Commission (SEC) and the state in which they’re being sold. They can provide investors who are willing to accept the risk with a reliable return, but investors should be on the lookout for scams in this arena.
How Notes Payable Work
Notes payable include terms agreed upon by both parties—the note’s payee and the note’s issuer—such as the principal, interest, maturity (payable date), and the signature of the issuer. There are a variety of types of notes payable, which vary by amounts, interest rates and other conditions, and payback periods. They are all legally binding contracts, similar to IOUs or loans.
Single-Payment Notes Payable: These notes payable require you to repay the lender the principal borrowed plus the interest charged all in one lump-sum payment by the due date specified in the note. Amortized Notes Payable: This kind of notes payable is most commonly used for home, property, or building loans from banks. Amortized promissory notes require you to pay fixed monthly payments that go toward the principal balance and interest. As the loan is paid down, more of the payment goes toward the principal and less toward interest. Negative Amortization Notes Payable: With negative amortization, the borrower can make payments that are lower than the interest costs, and the unpaid interest is then added to the principal balance. The downside for borrowers is that they will have higher total loan costs. Interest-Only Notes Payable: With these notes, the borrower’s payments only cover interest each month. The borrower must promise to pay the entire principal amount at the end of the loan.
What it Means to Individual Investors
Investors who hold notes payable as securities can benefit from generally higher interest rates and lower risk compared to other assets. Like with bonds, notes can provide a stream of reliable fixed income from interest payments. However, investors should be aware of potential scams. You can verify a promissory note by checking with the Securities and Exchange Commission’s EDGAR database. You can also call the securities regulator in your state.
How Business Owners Record Notes Payable
Business owners record notes payable as “bank debt” or “long-term notes payable” on the current balance sheet. To calculate interest expense, the business owner needs to multiply the principal amount by the interest rate by the period of time relative to the year in months to arrive at the accrued interest expense amount. Here is the formula: Pr x I X T/P = I or Principal amount x Interest rate x Time / Period (in months) = Interest If notes payable are due within 12 months, it is considered as current to the balance sheet date and non-current if it is due after 12 months.
