What are notes payable? Examples and differences from AP

Notes payable are formal agreements where one party borrows money and agrees to repay it over time, usually with interest. Business owners use notes payable for things like equipment purchases and inventory expansion. These agreements legally bind your business to repay borrowed funds, making them essential for managing cash flow and financing operations.

This guide breaks down what notes payable are, their key components, how they differ from accounts payable (AP), and when you might want to use them.

What are notes payable?

Notes payable, often referred to as promissory notes, are formal written agreements in which a borrower commits to repaying a specific amount to a lender within a defined timeframe, often with interest. The borrower records these agreements as liabilities on their balance sheet.

In business finance, notes payable serve as a funding source for companies looking to bridge cash flow gaps, finance major purchases, or expand operations. Whether you're managing temporary shortfalls, buying new equipment, or covering seasonal inventory costs, these formal loans provide the working capital needed to keep your business moving forward.

What's the difference between notes payable and other liabilities?

The key distinction between notes payable and other liabilities lies in their formal documentation and specific terms.

For example, while accounts payable typically arise from day-to-day business transactions with suppliers, notes payable involve written agreements with clearly defined repayment schedules, interest rates, and legal consequences for default. Also, trade payables might give you net 30 terms, but notes payable create binding contracts with banks, financial institutions, or private lenders.

Defaulting on a note payable can result in asset seizure, legal action, damage to your business credit rating, and potential personal liability if you provided a personal guarantee. For those reasons and more, you should carefully consider the terms before signing.

Key components of notes payable

Every note payable contains several essential elements that define the borrowing arrangement:

• Principal amount: The amount borrowed
• Interest rate: The cost of borrowing
• Repayment schedule: The timeline for repaying the loan, including the principal and interest
• Maturity date: The date by which you must fully repay the loan
• Collateral (if applicable): Assets pledged to secure the loan
• Parties involved: The borrower and lender

These details ensure clarity and accountability for both parties. Having all components clearly documented in the note also provides legal protection and helps prevent disputes over loan terms throughout the repayment period.

Common notes payable uses

Typical uses include traditional bank loans for equipment, lines of credit for working capital management, and vendor financing arrangements where suppliers extend credit for large orders.

Many businesses also use notes payable for real estate mortgages, vehicle financing, bridge loans during ownership transitions or major restructuring efforts, and acquisition financing when purchasing other companies or business assets.

Types of notes payable

Notes payable come in various forms depending on your business needs and the lender's requirements:

Short-term vs. long-term notes payable

Short-term notes payable mature within 1 year and typically finance working capital needs, seasonal inventory purchases, or temporary cash flow shortages. These appear as current liabilities on your company's balance sheet and often carry higher interest rates due to their shorter duration.

Long-term notes payable extend beyond 1 year and usually fund major capital expenditures such as real estate purchases, equipment acquisitions, or business expansions. Since lenders commit funds for extended periods, these loans often feature more comprehensive documentation and may include more restrictive conditions.

Secured vs. unsecured notes

Secured notes require collateral, which includes physical assets such as equipment, inventory, or real estate that the lender can claim if you default. This security reduces the lender's risk, often resulting in lower interest rates and more favorable terms for borrowers with valuable assets to pledge.

Unsecured notes rely solely on your business's creditworthiness and reputation. While they offer more flexibility since no assets are tied up as collateral, lenders typically charge higher interest rates and impose stricter qualification requirements to compensate for increased risk.

Notes payable in accounting

When recording notes payable in accounting systems, the initial entry involves debiting cash or another asset and crediting notes payable for the principal amount. This creates a liability on your books that reflects the obligation to repay the borrowed funds. Each subsequent payment typically reduces both the notes payable balance and records any interest expense incurred.

On the balance sheet, notes payable appear in the liabilities section, but their placement depends on the repayment timeline:

• Short-term liabilities: Notes due within 12 months
• Long-term liabilities: Notes with repayment periods beyond 12 months

This classification helps stakeholders assess your company's immediate cash flow requirements versus longer-term debt obligations.

Interest accrual follows the matching principle in accounting. As time passes, interest expense accumulates even if you haven't made a payment yet. Monthly journal entries typically debit interest expense and credit interest payable, or notes payable, depending on your system. When you actually pay the interest, you reverse the payable and credit cash.

Are notes payable current liabilities?

Whether notes payable are classified as current or non-current liabilities depends on their repayment schedule. Notes payable become current liabilities when the entire principal amount comes due within 12 months of the balance sheet date.

Consider a $50,000 note with monthly payments over 5 years. While the monthly portions due within the next year would be current liabilities, the remaining balance stays classified as long-term debt. However, a $10,000 short-term note due in 6 months would appear as a current liability.

Equipment financing provides another example. You’d split a 3-year equipment loan of $75,000 between current liabilities (the portion due within 12 months) and long-term liabilities (the remaining balance). Companies often create a current portion of long-term debt (CPLTD) line item to handle this split clearly.

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Debit vs. credit for notes payable

Notes payable follow standard liability accounting rules, which means increases are credits and decreases are debits. When you borrow money, you credit notes payable to increase the liability balance. When you make principal payments, you debit notes payable to reduce what you owe.

Let's review a simple example: a $25,000 loan at 8% annual interest for 3 years, with monthly payments of $782. The initial borrowing entry looks like this:

For the first month, interest accrues at $167:

When you make your first monthly payment, the $782 splits between interest ($167) and principal ($615):

This combined entry shows how installment payments work in practice. The principal portion reduces your notes payable balance, while the interest portion satisfies the accrued interest expense. As the loan balance decreases over time, the interest portion of each payment will get smaller while the principal portion will grow larger.

Some companies prefer to record interest accrual separately from payments, while others combine everything into the payment entry. Both approaches achieve the same result; they just differ in timing and the number of journal entries involved.

How to record notes payable: Journal entry examples

Notes payable transactions involve several journal entries from initial borrowing through final repayment. Let's walk through two common scenarios with step-by-step examples to show how these entries work.

Example 1: Short-term business loan

ACME Corp. borrows $10,000 from a bank on January 1 with a 6% annual interest rate, due in 6 months.

Step 1: Issuing the note payable (January 1)

Step 2: Accruing interest (monthly, January 31)

Interest calculation: $10,000 * .06 * (1/12) = $50

Step 3: Repaying note and interest (July 1)

Total interest for 6 months: $50 * 6 = $300

Example 2: Equipment purchase note

ABC Co. purchases equipment worth $25,000 on March 1, signing a 1-year note at 8% annual interest.

Step 1: Issuing the note payable (March 1)

Step 2: Accruing interest (monthly, March 31)

Interest calculation: $25,000 * .08 * (1/12) = $167

Step 3: Repaying note and interest (March 1st, following year)

Total interest for 12 months: $167 * 12 = $2,004

These examples demonstrate the accounting treatment for notes payable from start to finish. Following this pattern helps you maintain accurate financial records and proper interest expense recording throughout the loan period.

Notes payable vs. accounts payable

When managing business finances, you'll encounter two primary types of short-term liabilities that might seem similar at first glance: notes payable and accounts payable (AP). While both represent money your business owes, they serve different purposes and come with distinct characteristics.

Notes payable are formal written promises to pay a specific amount of money by a certain date, typically accompanied by interest charges. These legal documents create binding agreements between your business and lenders, whether banks, suppliers, or other creditors.

Accounts payable, on the other hand, represent the informal debts your business accumulates through regular operations. These arise when you purchase goods or services on credit from suppliers without signing formal promissory notes. Your monthly office supply bill or inventory purchases from vendors typically fall into this category.

Here's a table for quick comparison:

The key differences lie in formality and documentation. Notes payable require signed agreements with specific repayment terms, while AP stems from standard business transactions with implied payment expectations.

Timing

The timing of these liabilities differs significantly in duration and payment flexibility. Notes payable typically have fixed maturity dates spelled out in the written agreement. Depending on the terms negotiated, you might have 30 days, 12 months, or even several years to repay. Deviating from the schedule can trigger penalties or legal consequences.

AP operates with more flexible timing arrangements. While vendors expect payment within their standard terms, these deadlines are generally negotiable. You can often arrange extended payment terms during cash flow challenges or take advantage of early payment discounts when funds are available.

Collateral and risk

Notes payable carry higher risk due to interest payments and potential collateral such as equipment. Banks and formal lenders want protection for their investment, so they may place liens on equipment, inventory, or other business assets. Some notes payable are unsecured, but these typically come with higher interest rates to compensate for increased lender risk.

Accounts payable rarely involve collateral requirements. Suppliers and vendors rely on your business relationship and credit history rather than physical security. The main risk for vendors is non-payment, which they typically handle through credit limits, payment terms adjustments, or service suspension rather than asset seizure.

Accounting treatment

Notes payable require more detailed documentation in your accounting records. You must track the principal amount, interest rate, payment schedule, and any collateral pledged. Interest expense accumulates over time and appears on your income statement, while the principal balance reduces with each payment.

Accounts payable accounting focuses on tracking vendor balances and payment due dates. The recording process is typically more straightforward: You create the liability when you receive goods or services and eliminate it when you pay. You don’t need any interest calculation unless you pay late.

Notes payable vs. notes receivable

Notes payable represent a borrower’s obligation to repay borrowed capital, while notes receivable signify a lender’s right to receive payment. Notes receivable are recorded as assets on the balance sheet, categorized as current or non-current depending on the collection period.

Best practices and mistakes to avoid

To maintain financial health and meet repayment obligations, here are a few ways you can efficiently manage your notes payable, as well as some common mistakes and how to address them:

Best practices

• Understand repayment terms: Know the specifics of each loan agreement, including interest rates, payment schedules, and any penalties for early or late payments. Keep copies of all loan documents easily accessible so you can reference the exact terms when making financial decisions.
• Monitor cash flow: Monitor your incoming and outgoing funds closely to ensure you'll have sufficient cash available when loan payments come due. Regular cash flow analysis helps you spot potential shortfalls before they become problems.
• Track due dates: Maintain a calendar or system that alerts you well in advance of upcoming payment deadlines. Missing payments can damage your business credit score and trigger penalty fees that add unnecessary costs to your borrowing.
• Communicate with lenders: Build positive relationships by staying in touch with your creditors, especially if you anticipate any payment challenges. Proactive communication often leads to more flexible arrangements and shows that you're a responsible borrower.
• Plan ahead: Look beyond immediate payments and consider how your debt obligations fit into your long-term financial goals. This forward-thinking approach helps you make informed decisions about taking on new debt or paying down existing balances early when cash flow allows.

Mistakes to avoid

• Missing payment due dates: Late payments can trigger penalty fees, higher interest rates, and damage your credit rating. Set up calendar reminders or automated alerts at least 1 week before each payment is due, and consider scheduling payments a few days early to account for processing time.
• Poor record keeping: Disorganized documentation makes it difficult to track balances, payment schedules, and terms. Maintain a detailed log of all notes payable with original amounts, interest rates, payment schedules, and remaining balances. Keep all loan documents in a centralized filing system.
• Ignoring interest rate changes: Variable-rate loans can increase your payment obligations without warning. Review loan terms regularly and monitor interest rate adjustments. Budget for potential increases and consider refinancing if rates become unfavorable.
• Mixing personal and business debt: Combining different types of debt creates confusion and potential legal issues. Keep business notes payable completely separate from personal obligations, using dedicated business accounts and documentation systems.
• Overlooking pre-payment penalties: Some lenders charge fees for early repayment. Check your loan agreements before paying extra toward your principal to avoid unexpected costs that could outweigh the interest savings.

Use Ramp to simplify notes payable management

Notes payable are useful for financing growth and managing large-scale investments. While Ramp doesn’t offer notes payable financing, we simplify the management of your full financial picture, including these liabilities.

By integrating your accounting software with Ramp, you gain clearer visibility into your cash flow. Our automation tools streamline accounts payable, track spending, and deliver financial insights to help you effortlessly manage all your obligations and keep your business agile.

Watch a demo video to learn why Ramp customers save an average of 5% a year across all spending.