If You’re Lending Money in Michigan and Want Compound Interest, Your Note Better Say So
Banks and financial institutions make loans and prepare promissory notes every single day. Their documentation is the product of decades of institutional knowledge about the law, written by attorneys who understand what should and should not be included in a note to protect the lender’s interests and to comport with their understanding of the loan’s terms, including the amount of interest to be paid by the borrower. But these large institutional lenders aren’t the only ones making loans.
Individuals frequently make loans to family members or others without counsel, perhaps using an online template or other document that may or may not be legally compliant or reflect the parties’ intent. Unfortunately, such DIY lending can lead to situations where the lender’s expectations are not reflected in the note’s terms or are, in fact, contradicted by applicable law.
One example of this disconnect, involving how interest was to be calculated, recently crossed my desk and offers a cautionary tale about the importance of clarity – and counsel – when preparing even the most basic loan documentation.
A Michigan trust set up by a father loaned money to the father’s son. The loan was secured by a mortgage on the son’s home, with a mortgage note that provided for interest to accrue at “5% per annum.” However, the note did not specify whether that interest was to be simple or compounded. When the son defaulted on the loan, an accountant was charged with calculating the balance due on the note, including the accumulated interest.
The accountant assumed that the interest was compounded monthly and therefore increased the mortgage note balance each month by the amount of the unpaid interest. But that was a mistaken assumption, as Michigan law makes clear.
In Michigan, the law disfavors compound interest and will presume interest is to be calculated on the basis of simple interest unless the parties specifically agree otherwise or other circumstances are present. This rule was set forth in the case of Norman v. Norman, 201 Mich App 182, 506 NW2d 254 (1993), in which the court stated:
In light of the general rule favoring simple interest over compound interest, and in light of the case law, we reach the conclusion that there is a rule to apply regarding simple versus compound interest. Namely, in the absence of a statute to the contrary, an explicit agreement of the parties, or some special circumstance dictating otherwise, the rule in this state is that interest shall be calculated on the basis of simple interest rather than compound interest.
Similarly, in Nation v WDE Elec Co, 454 Mich 489; 563 NW2d 233 (1997) the Michigan Supreme Court affirmed the holding in Schwartz v Piper Aircraft Corp, 90 Mich App 324, 327; 282 NW2d 306 (1979), which stated that “courts which have dealt with similar problems have uniformly rejected compound interest except where specifically authorized by statute or in cases where compounding of interest was granted as a penalty for some misconduct on the part of a defendant.”
The presumption of simple interest in Michigan is mirrored in the law of other states. For example, the Texas Supreme Court has held that “because Texas law disfavors compound interest, an agreement for interest on unpaid amounts is an agreement for simple interest absent an express, clear, and specific provision for compound interest.” Samson Expl., LLC v Bordages, 694 S.W.3d 195 (2024). Furthermore, the Texas Supreme Court also held that the phrase “per annum” or “annually” does not create a presumption for compound interest. Compound interest must be clearly stated.
The rulings of the Michigan and Texas courts also follow a decision of the United States Supreme Court. In Cherokee Nation v. United States, 270 US 476 (1926), the Supreme Court held that the general rule is that “even as between private persons . . . in the absence of a contract therefor or some statute, compound interest is not allowed to be computed upon a debt.”
Accordingly, when preparing a promissory note, the lender needs to make a specific decision as to whether interest will be compounded and, if so, specifically provide for that method of calculation in the terms of the promissory note.
Whether you are a large national bank or a generous and helpful parent, loaning a significant amount of money is a legal enterprise that should not be undertaken lightly. If you would like assistance or have questions regarding documenting a loan to friends, family, or others, please contact Robert Kaplow at Maddin Hauser.