Updated November 9, 2020:

Notes payable to banks are formal obligations to banks that an individual or business is required to pay. These are usually in conjunction with a loan agreement.

What Are Notes Payable?

Notes payables are like promissory notes. They are offered to a borrower from a lender with a written, formal agreement. The agreement stipulates that the borrower is required to pay the lender a sum of money and any acquired interest within a specified time period. A notes payable gives a bank the right to sue a borrower if they do not hold up their end of the agreement within the time allotted.

Notes Payable Interest Rate

Interest rates for notes payable are determined by considering the time period given for repayment and prime rates. Prime rates are interest rates given to a bank's best customers. Once the interest rate is determined for the loan, it will be specified in the notes payable document.

After the principal payment is covered, any owed interest that hasn't been paid is accrued before the financial statements are prepared. Sometimes, a note is signed with an overdue invoice under the following circumstances:

  • A company needs a payment extension.
  • A company borrows cash.
  • A company is exchanging an asset.

If a company is asking for the original credit period to be extended for the amount owed, they will usually need to provide a signed note. This note transfers the liability for the loan agreement from accounts payable into notes payable. If the amount is due before the end of the year after the date that the balance sheet was prepared, the notes payable is classified as a current liability.

Accounts Payable Versus Notes Payable

Accounts payable and notes payable have the same purpose. They are both created with the goal of getting a customer to pay what they owe on a loan. They are still different, though they share a common goal. For starters, they are different types of contracts.

Accounts payable are usually only verbal agreements. They take place between a buyer and a seller. You may have some written documents like purchase orders or invoices, but the agreement itself isn't usually in writing.

Notes payable agreements are written and include documents like loan contracts. These are very formal agreements, and they are frequently complicated and lengthy.

While accounts payable agreements are usually repaid quickly without any interest, notes payable cover longer periods of time. Accounts payable might even offer a small discount on the payment if the invoice is paid quicker than usual, like within 10 days instead of the usual 30. Notes payables provide maturity dates for the loan and can extend over months and even years.

There is no collateral for accounts payable, and it's not usually necessary anyway. Notes payable, however, frequently use the purchased assets as collateral for the loan amount.

Risks Involved With Accounts Payable and Notes Payable

Many companies are fine with the risks involved when they give short-term credit to their trusted customers. If a customer doesn't meet the due date of their accounts payable agreement, the company might choose to then form a notes payable giving the customer more time to pay, but now with interest charged. This ends up being a low-risk practice overall for the company as they will tend to only work with reliable customers.

Lenders like banks will use notes payable agreements along with their loan agreements when loaning to a high-risk customer. Perhaps this customer has poor credit or a history with the bank. The notes payable provides set interest and a specified maturity date.

How Can a Company Treat Its Notes Payable?

There are two different ways a business can treat its notes payable agreements. They are:

  • Short-term liability
  • Long-term liability

Short-term liability notes payable agreements have shorter terms. If the payment due date is within a year from when the loan was given, this is a short-term liability. Long-term liability notes payables may cover a payment due date beyond a year from the date of the agreement.

Annual interest on a notes payable is calculated starting with the principal plus any interest already accrued. This sum is multiplied by the set interest rate for the loan. In the case that an interest rate is not specified in the agreement, the assessed value of the services or goods originally purchased determines the exchange value.

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