What is a Contractual Interest Rate?

A contractual interest rate is the specific rate included within the terms of a note payable or bond payable. This rate is multiplied by the face amount of the note or bond to derive the amount of interest actually paid to a note or bond holder. The contractual interest rate could vary substantially from the market interest rate.

Characteristics of a Contractual Interest Rate

The key characteristics of a contractual interest rate are as follows:

Defined in a contract. The rate is explicitly stated in the loan or bond agreement and forms the basis for calculating interest payments.
Basis for periodic payments. The contractual interest rate is applied to the principal to calculate periodic payments (e.g., monthly, quarterly, or annually). Payments may include just interest (for interest-only loans) or interest plus principal (for amortizing loans).
May differ from market rates. It reflects the rate agreed upon between the borrower and lender, which may be higher or lower than prevailing market rates at the time of agreement.
Expressed annually. It is typically stated as an annual percentage rate (APR), though payments may be made more frequently, requiring the rate to be prorated (e.g., monthly interest).
Does not include fees. The contractual interest rate excludes origination fees or other costs associated with the loan, which may be captured in the effective interest rate or APR.

Understanding the contractual interest rate is crucial for borrowers and investors to assess the terms and financial implications of a loan or bond.

Example of a Contractual Interest Rate

As an example of a contractual interest rate, a lender offers a borrower a $50,000 loan with a maturity date in 36 months. The contractual interest rate on this loan is 8% per year. The borrower accepts the arrangement, and is then obligated to pay the lender $4,000 per year in interest, which is calculated as follows:

8% Contractual interest rate x $50,000 Loan amount = $4,000 Interest payable per year