If you lend money to a friend or family member, you might 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. (Check out our promissory note forms.)
A promissory note is a written promise, basically an IOU, to pay money to someone. The note document serves as written evidence of the amount of the debt. To start, decide how much money you'll lend, the amount of interest you'll charge, if any, and the type of repayment schedule.
If the borrower doesn't meet the repayment terms, you can sue and get a judgment for the amount owed plus court costs and maybe lawyer's fees.
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.
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 might prefer to lend the money interest-free.
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).
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.
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