If you lend 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 in order to detail and record the terms of the loan agreement.
Promissory Note Basics
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:
- how much money you will lend
- the amount of interest you will charge, if any, and
- the type of repayment schedule.
Should You Charge Interest?
Charging a friend or family member interest strikes some people as ungenerous. But this view is often based on a misconception about the function of interest, which is to fairly compensate the lender for using money that could have been earning interest elsewhere.
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 Harry the money.
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 treat you as though you had 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 Nolo's 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%. You're probably not likely to charge your friends and relatives an excessive interest rate, so the usury laws are unlikely to present a problem. But if the rate you and the borrower have agreed on exceeds 10%, check your state's usury law.
To see all of our availale downloadable forms, check out our Promissory Note Forms.
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