lending money to friends and family, it is important that
you protect yourself by means of a promissory note.
Never be content with a handshake or someone's
word that they are going to pay you back. It is unfortunate, but
people tend to forget and disputes do occur. You can protect
yourself by generating and executing a formal document that
details the specifics and terms of your loan agreement,
otherwise known as a promissory note.
Basics of Promissory Notes
A written promise that monies is going to be repaid is
called a promissory note. This document will serve as a written
paper trail/evidence of the amount owed and the terms under
which the loan will be repaid, including interest rates (if any)
and the schedule for repayment.
To begin, determine:
- How much money you are going to lend?
- Are you going to charge interest? If yes, how much?
- What is the repayment schedule going to be?
Determine Whether or Not to Charge Interest
It may be considered as not being generous if you charge
your family member or friend interest. However, the function of
interest is to compensate you for lending the money.
For example, suppose Jon lends Mike $4,000 for a year,
interest-free. If Jon had placed the money into a certificate of
deposit, he would have earned interest on the funds for that
period of time. By lending Mike the money interest-free, Jon
endures the cost of lending the money to Mike.
In any event, when lending a small amount of cash to a family
member or friend, you may decide to lend the money without
It is important to note that if the IRS finds out about an
interest-free loan, they will 'impute' interest on the loan.
Meaning, they will assume that you have earned interest on the
loan and require you to report it as taxable income. This will
not be an issue for most personal loans. As long as the total
amount provided to the borrower is less than the gift-tax
exclusion amount for the calendar year, uncharged interest can
be treated as a tax-free gift. Get more information about
gift tax exclusions.
Higher interest rates. Most states have usury laws that put a
limit on the interest rate lenders can impose on loans --
typically ranging between 10 - 20%. It is unlikely that
relatives and friends are going to be charged extreme interest
rates, so usury laws are usually not a problem. However, if you
want to charge a rate that is more than 10%, check your
state's usury law.
Types of Repayment Plans
It is important that you and your borrower come to a clear
understanding/agreement on a plan for repaying the loan.
Installment Payments in Equal Amounts - This type
of payment plan calls for equally regular payments for a
specified amount of time until the loan is paid off. Regular can
mean weekly, monthly or yearly.
In the event that you are charging interest, a portion of each
payment is going to go towards interest and the rest toward
principal. When the last payment is made, the loan and interest
are paid in full.
You can get a
sample promissory note.
Borrowing from Family
10 Reasons Not to Lend to Friends
Without Giving Money/Loans
How to Say No
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