Lending to Family and Friends: Why a Promissory Note Helps

Loans between family and friends often go wrong because the terms were never written down. A promissory note records the amount, repayment plan and what happens if payments stop.

What a promissory note includes

• Names of lender and borrower and the date.
• The amount borrowed.
• Interest rate, if any, and payment schedule.
• Late fees and what counts as default.
• Whether the loan is secured by property.
• Signatures, and witnesses or a notary if desired.

Interest and taxes

Interest above certain levels may need to be reported as income, and loans with very low or no interest above a set size can have federal tax consequences. State usury laws cap interest rates. Check current IRS guidance or ask a tax professional.

If it is not repaid

1. Send a polite written reminder.
2. Offer a revised payment plan in writing.
3. Send a demand letter.
4. Consider small claims court, where a signed note is strong evidence.
5. Keep payment records.

Good practice

• Treat it like a real loan even with family.
• Be clear whether it is a loan or a gift.
• Do not lend more than you can afford to lose.

Why family loans go wrong

Loans between relatives and friends fail less often because of the money than because of unclear expectations. The lender assumes repayment will be quick, the borrower assumes flexibility, and nobody wrote down the terms. When payments stop, both sides feel hurt. A written note, a repayment schedule and a few ground rules protect both the loan and the relationship.

Gift or loan: decide in advance

• A gift does not need to be repaid, but large gifts may require a federal gift tax return, even though tax usually is not owed.
• A loan is expected to be repaid and should have a note.
• Forgiving a loan later may have tax effects.
• Treat the two differently in writing, so an executor or sibling understands later.

Interest rules

If you charge no interest or a very low rate on a large loan, the IRS may treat part of the interest as imputed income and gift. There are exceptions for smaller loans. Charging a reasonable rate and keeping records avoids the question. State usury laws also cap rates. Ask a tax professional about the current applicable federal rates.

Setting up a repayment plan

1. Choose a fixed monthly amount and a due date.
2. Set up automatic transfers if possible.
3. Keep a ledger or use a loan tracking app.
4. Agree what happens if the borrower misses a payment.
5. Put any changes in writing.

If the loan goes unpaid

Start with a friendly written reminder, then a demand letter. A signed note and records of payments make a small claims case straightforward. If the borrower dies, the debt is generally a claim against their estate. See our guides to demand letters and small claims court.

Terms to know

• Principal: the amount borrowed.
• Applicable federal rate: minimum interest rates the IRS uses for certain loans.
• Imputed interest: interest the IRS treats as paid even if not charged.
• Demand note: payable whenever the lender asks.
• Acceleration: making the full balance due after default.
• Forgiveness: a lender releasing the debt.

Scenarios

1. A parent lends a child money for a car. A note and monthly payments keep it clearly a loan, not a gift.
2. A friend lends money for a business. A signed note with payment dates and a late fee helps if payments stop.
3. A sibling lends for a down payment. A note and a recorded lien can protect the lender and clarify what happens if the house is sold.

Frequently asked questions