In many instances lending money to a friend or family member is done with good intentions. You would like to support someone you love in a difficult situation to purchase a house or open a business. But once money comes into the scene, then relations can soon become distorted.
I have witnessed thousands of situations when the deficiency of the definite agreement destroyed a friendship or divided a family. A simple, written loan agreement does not mean you do not trust the other person; it means you respect them, and you respect the seriousness of the money involved. It removes guesswork and hurt feelings later on.
This guide will give you a simple framework for writing your own agreement. We will also cover the essential tax rules that Google will use to judge if your “loan” was actually a “gift.” Ignoring these rules can lead to big problems with the IRS for both the lender and the borrower.
Why You Must Have a Written Contract
When lending money to anyone, especially family, the document serves two crucial purposes:
1. It Protects Your Relationship
A written contract spells out the expectations for both sides. It answers all the tough questions upfront: How much is owed? When is the first payment due? What happens if a payment is late?
When you agree to these points while everyone is happy, there is nothing to fight about when things get tight. The contract is a neutral third party that holds everyone accountable.
2. It Protects You from the IRS
If you lend a large amount of money to someone and do not charge any interest, the Internal Revenue Service (IRS) might look at that money and say, “That was not a loan; it was a gift.”
Why does this matter? The lender might owe gift tax on that money, and the borrower could lose tax deductions later on if the loan goes bad. A proper contract, with a clear interest rate, proves to the government that this is a real business deal, even if it is between your brother and you.
The Six Essential Parts of Your Loan Agreement
An extraordinary loan agreement is not required to be complicated with terms instead of an ordinary language. It simply must be unambiguous, exhaustive and signed. Below are the six parts that you need to include:
1. Defining the Parties and the Date
The first step is simply identifying who is who and when the deal starts.
- Lender: The person giving the money (Your Name/Business Name).
- Borrower: The beneficiary of the funds (Name of Friend/Name of Family Member).
- Date: The day upon which the agreement is signed.
Simple Wording Example: Words and phrases Signed Date “This Loan Agreement is entered into as at [Date] between [Lender Full Name] (the “Lender”) and [Borrower Full Name] (the “Borrower”).
2. The Loan Amount (Principal)
Write figures and words of the exact amount of the loan used to borrow. This will deter confusion in case a number is spelt out.
Simple Wording Example: “The Lender concurs that he will lend the Borrower the principal amount of $50,000.00 (Fifty Thousand Dollars and Zero Cents).
3. The Interest Rate (A Critical Tax Tip)
This is the most important part from a legal and tax standpoint. Banks charge interest so they can make money. You need to charge interest to make the IRS believe your loan is legitimate, not a disguised gift.
The Applicable Federal Rate (AFR): The IRS publishes a monthly rate called the Applicable Federal Rate (AFR). This is the minimum interest rate you must charge on a loan for the government to accept it as a true loan. If you charge 0% interest, the IRS will automatically treat the forgone interest as a gift, which can trigger tax complications.
- Tip from the Field: Always use an interest rate that is equal to or higher than the current AFR. You can find these rates published monthly on the IRS website.
- How to Handle It: The point is that even in the case you are planning later to forgive the interest, you still have to mention a rate in the deal.
Simple Wording Example: The Loan will bear an interest rate of 3.5% (three and one-half percent) on the outstanding balance (unpaid) of the Loan.
4. The Repayment Schedule
By what means will the Borrower pay the money back? Be very clear of the frequency, sum and the ultimate date. A couple of general methods of managing this are:
- Installment Payments: The most common. The Borrower has a specific amount he or she pays every month until it is paid off (principal plus interest).
- Example: The Borrower would make payments in form of $500.00 one day in every month, beginning on [Start Date].
- Balloon Payment: In this Borrower will have to pay in small payments (perhaps, only interest) within a definite time, and in the end, they are going to repay the whole amount of money in one huge payment.
- Example: The Borrower will pay an interest only on the first day of each month. All the full amount of that unpaid principal, consisting of any accrued interest is to be paid in a single spurt payment on [Final Due Date].”
- Demand Loan: This is a dangerous one to the family loans but easy. The Lender may request the repayment of the money any time. The Borrower is required to pay back within a given period after the demand (e.g. 30 days).
Simple Wording Example (Installment): “Repayments shall be made in 60 (sixty) monthly payments of $899.32, beginning on January 1, 2026, and ending on December 1, 2030.”
5. Collateral (Security) – The “What If” Clause
A loan is secured if the Borrower pledges an asset as collateral. If the Borrower fails to pay, the Lender can take that asset to cover the loss. A loan without collateral is an unsecured loan.
- Secured Loan: Greatly reduces the Lender’s risk. For example, if the loan is to buy a car, the car could be the collateral.
- Unsecured Loan: This relies solely on the Borrower’s promise to pay. Most family loans are unsecured.
Even if you do not use collateral, you must define the situation where the Borrower fails to meet the repayment schedule.
6. The Default Clause
This section clearly stipulates what constitutes a default and what the Lender can do with it. A default will normally occur in case of 30 days of late payment, or where the Borrower becomes bankrupt.
Simple Wording Example: The defaulting state is that in case any scheduled payment remains unpaid within 15 days upon the due date to the Lender. At default, Lender may make a declaration to the effect that the rest of the principal and allowable interest is immediately due and payable.
Critical Tax Tips to Protect Yourself and the Borrower
As a former paralegal, the tax piece is where I saw the most confusion. Follow these three steps to keep your loan agreement clean in the eyes of the government:
Tip 1: Never Charge 0% Interest
If the IRS reviews your loan and sees a 0% interest rate, they will assume that you are trying to avoid paying gift tax or that the money was simply a cash gift. They will then impute (assign) interest to the loan using the AFR.
- What this means: You, the Lender, will be forced to pay tax on the interest income you should have earned, even though you did not actually receive the money. The Borrower will get a tax deduction for interest they never paid. It makes for a very messy situation.
- Solution: Check the IRS AFR table the month you make the loan and use that rate or a higher one.
Tip 2: Document Every Single Transaction
Do not deal in cash. Do not mix the loan payments with birthday checks or holiday money. Every payment should be made via bank transfer, check, or a financial app (like Zelle or Venmo) that clearly labels the payment as “Loan Repayment” or “Interest Payment.”
Why this matters: If the loan ever goes into default and you need to deduct the loss on your taxes (claiming it as a “bad debt”), you will need clear, separate records showing the full history of the loan, the payments, and the outstanding balance. The IRS will ask for proof of these payments.
Tip 3: Handling Loan Forgiveness
Sometimes, life happens, and you might want to forgive the remaining balance of the loan. While this is a wonderful gesture, it has tax implications.
- If you forgive the loan, it becomes a Gift.
- If the forgiven amount is more than the annual gift exclusion limit (check the current year’s limit with a tax pro), the amount over the limit counts against your lifetime gift tax exemption.
- The Borrower: When a loan is forgiven, the forgiven amount is generally considered taxable income to the Borrower. This means the Borrower may have to pay income tax on the amount they no longer have to pay back.
The Solution: If you plan to forgive the loan, treat the forgiveness as an annual gift. Every year, you can forgive up to the gift exclusion limit without any major tax paperwork. Do this by sending a letter to the Borrower stating, “I hereby forgive $18,000 of the outstanding loan principal as an annual gift for the year 2025.” Notice of Landlord Entry: Your Complete Guide
Final Thoughts from My Experience
The core of a family loan is trust. The goal of this document is not to start a legal war; it is to define the boundaries of that trust so it does not get tested.
As a legal professional, here are my final practical tips:
- Sign and Date: Have the parties sign it and have a witness (not legally mandatory, but it gives some weight) sign the document. Both sides are expected to retain a copy.
- Keep a Separate Log: Bank statements are not the only reliable reasons you can depend on. Prepare a basic spreadsheet using which the balance at the beginning, each payment received, and the balance are tracked. This simplifies the task of tax preparation.
- Do not Wait: If payments start to lag, address it immediately. Do not let one missed payment turn into three. The contract gives you a simple, non-emotional way to open that conversation.
Lending money to family or friends can be a great thing when done correctly. Use this template, follow the tax rules, and you will protect both your financial future and your relationship.
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