When 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 charging interest.

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.

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