Many people turn to friends and family for loans when buying a large asset or starting up a business. Lending to family and friends is a high-risk undertaking with little to gain for the lender beyond the satisfaction that comes with helping someone you know. When it comes to lending money, even to family and friends, one common refrain you will hear again and again is “get it in writing.”
There are good reasons to get a loan agreement, sometimes called a Promissory Note, in writing, but you may have other questions about lending money to people you know. Here are a few common questions and answers about lending money to family and friends.
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Is lending money legal?
Yes, it is. It’s legal to lend money, and when you do, the debt becomes the borrower’s legal obligation to repay. You can take legal action against your borrower in the case of a default in small claims court. This may seem harsh, but it’s important to understand it up front. A loan between loved ones has the same legal weight as a bank loan.
If you are lending money to a friend or family member, you may want to get the details in writing and signed by all parties in case there’s a conflict or misunderstanding. If all you have is a verbal understanding and a handshake, that may not be enough to prove the details of your agreement. A signed, written contract is far better than a handshake.
Can I lend money to a friend and charge interest?
Yes, you can, but the tax ramifications can be tricky and complicated. You would have made interest on the money if you had kept it an interest-bearing account, and that’s one good reason to charge interest. However, casual lenders could unwittingly cause themselves tax headaches down the road if they don’t structure their loans wisely, get all of the details in writing, and have the written agreement signed by the lender(s) and lendee(s). Ask a lawyer if you’d like to set up your loan agreement to avoid costly mistakes in the future.
Should I avoid lending money because of potential legal conflicts?
It all depends. Consider your financial situation and goals:
- Can you afford to tie up this money?
- If other lenders have turned the borrower down, do you really want to take on the risk? What if the borrower runs into unexpected challenges?
- Are you and other members of your family prepared to take legal action in case of a default?
- Are you prepared to forgive your borrower’s debt to keep the peace?
If losing this amount of money would cause serious financial harm to you, then you may well decide to say so and avoid making the loan. If you go forward, you may want to set terms, in a written Promissory Note, that both parties can agree on, and stick to them.
How can I make sure I will be paid back?
While there are few guarantees in life, here are some tips that may increase the odds that you will be paid back in full.
Tip 1: Put the terms in writing.
You can use a legally binding and easy to fill out loan agreement, called a Promissory Note, to capture the details of your loan. Of course, it’s easier, and emotionally gentler, to have a spoken promise between friends, but the trouble comes when one or both of the parties can’t recall the terms a year or two in the future. A written agreement averts an uncomfortable debate later.
Tip 2: Lay out all key loan agreement terms.
- Names and addresses of the parties to the agreement
- Loan amount (principal)
- Interest rate
- Repayment terms, including any late fees or penalties
- Signature lines
The repayment terms may be geared to the parties’ circumstances. Two smaller payments each month might work better for the borrower, for example. Alternatively, if the borrower is expecting a major financial boost such as a tax refund, a lump-sum repayment might make sense. In any case, you may want to clearly specify the due date.
You might also specify the collateral for the loan, and, if applicable, specify that the loan obligation is transferable to a third party.
Tip 3: Spell out your recourse if the borrower defaults.
If the borrower defaults, or fails to pay what they owe, you may:
- Modify the terms of the agreement to account for changes in circumstances
- Take collateral, if any was given to secure the loan
- Go to small claims court to get a judgment
A Few Final Points to Consider
With the Rocket Lawyer Promissory Note, you can cover the legal basics, including the loan amount, repayment, and default provisions.
Should you have trouble collecting repayments, review these tips for collecting personal debt. You might need a lawyer to renegotiate the loan terms, recoup a portion of the debt in a settlement agreement, or help the borrower obtain a debt consolidation loan.
Need case-specific advice? Ask a lawyer if your situation requires affordable, high-quality legal services.
This article contains general legal information and does not contain legal advice. Rocket Lawyer is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.