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If you loan money to a friend or family member, you may feel that his or her word, or a handshake, is enough to seal the deal. Unfortunately, memories fade and disagreements do arise. Protect yourself by creating and signing a document (called a promissory note) that details the terms of the loan agreement.
A promissory note is a written promise to pay money to someone. The document serves as written evidence of the amount of the debt and the terms under which it will be repaid, including the repayment schedule and interest rate (if any).
To start, decide on:
Charging a friend or family member interest strikes some people as being ungenerous. But this view is often based on a misconception about the function of interest, which is to fairly compensate the lender for use of the money.
For example, suppose Joan lends Harry $5,000 for a year, interest-free. If Joan had put the money in a certificate of deposit, she would have earned interest on the money for that time period. By giving Harry the money interest-free, Joan bears the cost of lending the money to Harry.
Nevertheless, when lending a relatively small amount to friends or family, you may prefer to lend the money interest-free.
Interest-free loans and the IRS. The IRS, if it learns about your interest-free loan, can "impute" interest on the loan. That is, it will assume you have earned interest and require you to report it as taxable income. For most personal loans, this won't be a problem. Uncharged interest can be treated as a tax-free gift, as long as the total amount given to the borrower is less than the gift-tax exclusion amount for the calendar year. To learn about gift tax exclusions, see Estate and Gift Tax FAQ.
High rates of interest. Many states have usury laws that cap the rate of interest a lender can charge for loans -- often in the range of 10% to 20%. Friends and relatives aren't likely to charge excessive interest rates, so usury laws are rarely a problem. But if the rate the lender wants to charge exceeds 10%, check your state's usury law.
You and the borrower should agree on a plan for repaying the loan. Here are some options:
Installment Payments in Equal Amounts
In this type of payment plan, the borrower makes equal monthly (or yearly) payments for a specified number of months (or years) until the loan is paid off.
If you will be charging interest, part of each payment goes toward interest and the rest goes toward principal. When the borrower makes the last payment, the loan and interest are fully paid.
For a ready-to-fill-in promissory note for installment loans with interest, download Nolo's Promissory Note for Personal Loan (Installment Payments With Interest). For a ready-to-fill-in promissory note for installment loans without interest, download Nolo's Promissory Note for Personal Loan (Installment Payments Without Interest).
Lump Sum Payment of Principal and Interest
In many loans to friends and family members, the borrower pays off the loan all at once, at a specified future date. This payment includes the entire principal amount and the accrued interest, if any. Again, consult online calculators to figure out the total amount of interest due under your particular plan.
For a ready-to-fill-in promissory note for lump-sum payment loans with interest, download Nolo's Promissory Note for Personal Loan (Lump-Sum Payment With Interest). For a ready-to-fill-in promissory note for lump-sum payment loans without interest, download Nolo's Promissory Note for Personal Loan (Lump-Sum Payment Without Interest).
Balloon Payments
Although rarely used in loans between family and friends, you can also structure a loan with a balloon payment. In this plan, the borrower makes equal monthly payments for a period of time (the payments can cover interest and principal, or interest only). These payments pay off some, but not all, of the loan. Then, the borrower makes one final, large payment (called a balloon payment) that pays off the rest of the principal and the remaining interest.
For a ready-to-fill-in promissory note for a loan with a balloon payment, download Nolo's Promissory Note for Personal Loan (Installment Payments With Balloon Payment).
In a secured loan, the borrower pledges property (such as a car, computer, or house) as collateral to guarantee payment. If the borrower doesn't pay, the lender gets the property.
Most personal loans are unsecured. However, if you do want security for your personal loan, consider what property will be the security and what documents you need.
To start creating your promissory note, download one of Nolo's eforms (referenced above), or find them all in Nolo's award-winning Quicken® WillMaker Plus . In addition to promissory note forms, this software contains many legal forms, such as a will and living trust, that you need to protect your family and your assets, and to save on legal fees.
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