Businesses use notes payable when they borrow money from a lender like a bank, financial institution, or individual. Essentially, they’re accounting entries on a balance sheet that show a company owes money to its financiers.
Information to record the note payable in the company’s books usually comes from a promissory note—a written document that includes the borrowed amount, interest rate, repayment schedule, and signatures of the borrower and lender.
What type of account do notes payable fall under?
A note payable is a liability. This means the business must pay a sum to a lender under specific terms on a particular date. The portion of the loan due within 12 months is a short-term liability. You’ll usually see it on the balance sheet as “Current portion of long-term debt.”
The portion of the loan due after one year is a long-term liability.
In double-entry accounting, liabilities have natural credit balances. This means the liability account increases with a credit entry and decreases with a debit entry.
For example, to record a new note payable in your books, you would credit the notes payable account for the amount borrowed and debit cash for the loan proceeds.
On your company’s balance sheet, the total debits and credits must equal or remain “balanced” over time.
How are interest rates determined on a note payable?
Borrowers and lenders typically negotiate the interest rates on notes payable. Rates may be fixed, meaning they stay the same throughout the loan. Or, they may be variable, meaning they can fluctuate based on changes in market interest rates.
Different factors can affect the rate of interest on notes payable. For example:
- Creditworthiness of the borrower
- Duration of the loan
- Purpose of the loan
- Lender’s internal policies
Borrowers with a strong credit and financial profile may qualify for a low interest rate. A borrower with a weak credit history and a relatively less healthy financial profile may be in for a higher interest rate.
Other fees that may be included in the terms of a note payable include:
- Origination fee
- Closing costs
- Penalty fee
These fees increase the overall cost of borrowing. Consider them carefully when negotiating the terms of a note payable.
Notes payable example
Suppose a company needs to borrow $40,000 to purchase standing desks for their staff. To buy new furniture, the company applies for financing directly through the furniture store. The store approves the financing and issues a promissory note with the loan details, like the interest rate and the payment timeline.
On its balance sheet, the company records the loan as notes payable by crediting the notes payable liability account. It makes a corresponding entry to capitalize the furniture as a fixed asset.
As the company pays off the loan, the amount under “notes payable” in its liability account decreases. At the same time, the amount recorded for “furniture” under the asset account will also decrease as the company records depreciation on the asset over time.
How to calculate notes payable with interest
Recording notes payable in your books requires the following information:
- Loan amount
- Interest rate
- The repayment schedule (or number of payments)
For a simple loan with fixed monthly payments, calculate notes payable using the following formula:
Note that the above formula assumes that the interest is simple and does not compound over time. It also assumes that payments will and can be made at regular intervals and are equal in amount.
For example, a business borrows $50,000 at an interest rate of 5 percent per year, with a schedule to pay the loan amount back in 60 monthly installments.
Note payable = $50,000 x (1 + 0.05 x 60) = $56,500
The above formula assumes that the interest is simple and does not compound over time. It also assumes that payments will be made at regular intervals and are equal in amount.
For example, a business borrows $50,000 at an interest rate of 5 percent per year, with a schedule to pay the loan amount back in 60 monthly installments.
Note payable = $50,000 x (1 + 0.05 x 60) = $56,500
Loan calculators available online can give the amount of each payment and the total amount of interest paid over the term of a loan. These require users to share information like the loan amount, interest rate, and payment schedule.
Another related tool is an amortization calculator that breaks down every payment to repay a loan. It also shows the amount of interest paid with each installment and the remaining balance on the loan after each payment.
Simply subtracting any principal payments already made from the initial loan amount also shows the current note payable balance.
How to find notes payable on a balance sheet
Notes payable appear under the liabilities section of the balance sheet. The liabilities section generally comes after the assets section on a balance sheet. If notes payable appear under current liabilities, the loan is due within one year. If it’s located under long-term liabilities, it means the loan is set to mature after one year.
Here is a good example. On April 1, Company A borrowed $100,000 from a bank by signing a 6-month, 6 percent interest note. Below is how the transaction will appear in Company A’s accounting books on April 1, when the note was issued.
Another entry on June 30 shows interest paid during that duration to prepare company A’s semi-annual financial statement.
Notes payable vs. accounts payable
Both notes payable and accounts payable are liability accounts. The two are used to record different types of transactions. A note payable serves as a record of a loan whenever a company borrows money from a bank, another financial institution, or an individual.
On the other hand, accounts payable are debts a company owes to its suppliers. For example, a company records products and services it orders from vendors for which it receives an invoice in return as accounts payable, a liability on its balance sheet.
Accounts payable typically do not have terms as specific as those for notes payable. Unlike a loan, they usually don’t involve interest or have a fixed maturity date.
What happens when a company pays off notes payable?
Because the liability no longer exists once the loan is paid off, the note payable is removed as an outstanding debt from the balance sheet.
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