In this guide
What Are Usury Laws?
Usury laws are state statutes that cap the maximum interest rate a lender can charge on a loan. They exist to protect borrowers from predatory lending practices and to ensure that credit remains affordable. While the specific limits and rules vary widely from state to state, the underlying principle is consistent: charging excessively high interest is illegal.
Historically, usury laws applied to all loans, but modern statutes often carve out exceptions for certain types of lenders (like banks) and certain types of loans (like mortgages or credit cards). For personal loans between individuals, however, usury limits still apply in most states.
If a lender charges interest above the legal limit, the loan may be deemed 'usurious.' The consequences can include forfeiture of all interest, reduction of the principal, or even invalidation of the entire loan. In some states, the lender may also face fines or criminal penalties.
- Usury limits are set by state law, not federal law, so they vary by jurisdiction.
- Many states have a general usury limit (often 10-15%) but allow higher rates for written agreements or small loans.
- Some states have no usury limit for certain types of loans, but this is rare for personal loans.
- Usury laws do not apply to loans made by federally chartered banks, which can charge rates based on their home state's laws.
How State Usury Limits Work
Each state defines its own maximum interest rate, which is often tied to a benchmark like the federal prime rate plus a margin. For example, a state might set the limit at 10% per year for loans under $100,000, but allow higher rates for larger loans or for loans made under a written agreement.
Some states have tiered limits: a lower cap for small consumer loans, a higher cap for larger loans, and no cap for loans between sophisticated parties (like businesses). Others have a single statutory rate that applies unless another law (like a small loan act) allows a higher rate.
To find your state's limit, you can search for 'usury limit [your state]' or check your state's banking or financial regulation website. Keep in mind that the limit applies to the 'annual percentage rate' (APR), which includes not only the stated interest but also certain fees and charges.
- Example: In California, the general usury limit is 10% per year for personal loans, but loans of $100,000 or more are exempt from the limit.
- Example: In Texas, the maximum rate for most loans is 10% (criminal usury), but contracts can specify up to 18% under certain conditions.
- Some states, like South Dakota and Nevada, have no usury limit for private loans, but this is uncommon.
- Always check your state's specific statutes, as they can change.
Calculating Interest: Simple vs. Compound
The interest rate you write in your promissory note is a nominal rate, but the actual cost of the loan depends on how interest is calculated. Simple interest is calculated only on the original principal, while compound interest is calculated on the principal plus previously accrued interest.
Many states require that the usury limit be applied to the 'effective' interest rate, which accounts for compounding. If you compound interest more frequently (e.g., monthly vs. annually), the effective rate can exceed the nominal rate and potentially violate usury laws.
To avoid accidental usury, use simple interest unless you are absolutely certain that compounding won't push the effective rate over the legal limit. Even if compounding is allowed, you must clearly disclose it in the loan document.
- Simple interest formula: Interest = Principal × Rate × Time (in years).
- Compound interest formula: A = P(1 + r/n)^(nt), where n is the number of compounding periods per year.
- If your state's limit is 10% APR, a loan with a 9% nominal rate compounded monthly will have an effective rate of about 9.38%—still under the limit, but close.
- Always calculate the effective APR using a standard formula to ensure compliance.
Consequences of Charging Usurious Interest
If you charge interest above the legal limit, the borrower can raise usury as a defense if you sue to collect the debt. In many states, the court will void the interest portion, and some states even allow the borrower to recover double or triple the amount of illegal interest paid.
In extreme cases, the entire loan may be voided, meaning the lender cannot collect any principal or interest. Some states impose criminal penalties for willful usury, which can include fines and jail time.
Even if the borrower doesn't challenge the loan, a court may refuse to enforce the agreement if it finds the interest rate to be 'unconscionable.' This is more likely with very high rates, such as those exceeding 25-30%.
- Voiding of the loan: The lender loses the right to collect any money.
- Forfeiture of interest: The lender can only recover the principal amount.
- Statutory penalties: Some states allow the borrower to sue for a multiple of the excess interest paid.
- Criminal charges: Rare, but possible in cases of egregious violations.
Exceptions and Special Rules
Not all loans are subject to usury limits. Many states exempt loans made to corporations, limited liability companies, or other business entities, especially if the loan exceeds a certain amount. This is based on the idea that sophisticated borrowers don't need the same protections as consumers.
Loans made by regulated financial institutions (banks, credit unions) are often exempt from state usury limits due to federal preemption. If you're lending through a bank, the bank's home state's laws may apply, and they can 'export' that rate to borrowers in other states.
Some states have specific laws for 'small loans' (e.g., payday loans) that allow higher rates but impose other restrictions, such as maximum loan amounts and repayment terms. These are heavily regulated, and violating the rules can lead to severe penalties.
- Business loans: Often exempt if the loan is $100,000 or more (varies by state).
- Bank loans: Federally chartered banks can charge rates based on their home state, which may be higher than the borrower's state limit.
- Small loan acts: Allow higher rates for small-dollar loans but cap the loan amount and require licensing.
- Credit cards: Generally exempt from state usury limits due to federal law, but card agreements must comply with other regulations.
How to Draft a Promissory Note That Complies
To avoid usury issues, start by checking your state's usury limit and confirm that your intended interest rate is below it. If the rate is close to the limit, consider using a lower rate to account for any fees that might be considered interest.
Clearly state the interest rate as an annual percentage rate (APR) and specify whether it is simple or compound. If you use compounding, calculate the effective APR and ensure it's within the legal limit. Include a clause that says if the interest rate exceeds the legal limit, it will be automatically reduced to the maximum permitted rate.
It's also wise to include a 'savings clause' that states: 'If any provision of this note is found to be unenforceable, the remaining provisions shall remain in effect.' This can protect the principal amount if the interest is deemed usurious.
- Use a template from a reputable source, but customize it to your state's laws.
- Include the exact interest rate, how it's calculated, and the repayment schedule.
- Add a severability clause to preserve the principal if interest is voided.
- Consider having the note reviewed by a local attorney, especially if the loan amount is large.
- Keep records of the loan transaction, including the note, payments, and any correspondence.