Contractual Interest Rate

The contractual interest rate is the fixed interest rate explicitly written into a note payable or bond agreement, and it is this rate, applied to the instrument's face or principal amount, that determines the actual cash interest the borrower must pay the lender or bondholder on each payment date. It is also commonly called the coupon rate, stated rate, nominal rate, or face rate, and unlike the market rate of interest, the contractual rate is fixed at issuance and does not change over the life of the instrument, regardless of what happens to interest rates in the broader economy afterward.

A $1,000 bond carrying a 6% contractual interest rate pays $60 of interest per year, split into two $30 semiannual payments if interest is paid twice a year, regardless of whether the bond was sold for exactly $1,000, for more, or for less. This is the defining feature of the contractual rate: it fixes the dollar amount of cash the borrower must hand over, which is why it is sometimes described as the rate that determines what actually leaves the bank account, as opposed to the rate that determines how the transaction is valued.

When a bond or note is issued, the market, or effective, rate of interest prevailing for similar-risk borrowings may be higher or lower than the contractual rate printed on the instrument. If the market rate is higher than the contractual rate, investors will only buy the bond at a discount below its face value, since the fixed cash payments the contractual rate produces are less attractive than what they could earn elsewhere; if the market rate is lower than the contractual rate, the bond will sell at a premium, since its fixed payments are more generous than prevailing alternatives. This is exactly how discount on bonds payable and premium on bonds payable arise, and why the contractual rate and the market interest rate are rarely identical at the moment of issuance.

Because a bond issued at a discount still only pays interest based on its lower contractual rate while the borrower actually received less cash than the face amount up front, the true, effective cost of borrowing is higher than the contractual rate suggests; the opposite is true for a bond issued at a premium. This is why accounting for bonds amortizes any discount or premium into interest expense over the bond's life, so that the interest expense actually reported on the income statement converges toward the effective rate the market demanded at issuance, rather than simply mirroring the fixed contractual rate printed on the certificate.

Borrowers and investors both need to track the contractual rate separately from the market or effective rate, since the contractual rate determines the predictable cash flow schedule a bond or note generates, while the effective rate determines its true economic yield and its fair value if sold before maturity. A loan agreement, bond indenture, or note that specifies only a contractual rate without clarifying whether it is fixed for the full term or subject to periodic reset is one of the more common sources of disputes between borrowers and lenders, which is why loan documentation spells the contractual rate out explicitly and in detail.