Borrowing Money From a Friend or Family Member? Write a Contract

Borrowing money from a close friend or family member has its advantages, but it comes with some downsides, too. If the borrower takes too long to repay what they owe, or if they never repay at all, it could put a serious strain on the relationship. It could also cause the original “lender” financial stress if they need the money later.

It’s not all that surprising when you consider that total consumer debt in the U.S. as of the first quarter of 2022 was $15.84 trillion, credit card debt was $1.1 trillion and student loan debt is expected to exceed $2 trillion by 2024.

Before borrowing money from a friend, create a written contract. A contract can – and should – include any details about the loan, such as interest or repayment terms. It can also help ensure everyone is on the same page about when and how the money will be repaid. With that in mind, here’s how to write a contract for a loan between friends or family.

Friends and Family Loans

Borrowing money from friends or family members is surprisingly common in the United States. According to a Federal Reserve Survey of Consumer Finances, loans from friends and family amount to about $89 billion annually in the country.

Asking someone close to you for a loan can feel awkward, but it’s sometimes necessary. In most cases, it’s also a better option than taking out a predatory title loan or payday loan. These loans tend to have high interest rates and short repayment terms and can lead to bigger financial problems.

If you need immediate help, it may also be better than asking for assistance from a charity or another local service. Funds from these organizations often take days or weeks to approve, whereas a friend may be able to help out immediately.

A friend or family loan is often more flexible than loans offered by traditional lenders, too. These loans typically have minimal to no interest and more custom repayment terms. They also don’t require a certain credit score or debt-to-income ratio (DTI) to qualify.

But borrowing money from a loved one can be complicated. Even if everyone involved has a good, trusting relationship, it could lead to problems, such as:

  • Late payments or lack of payment
  • Financial stress
  • Strained relationships

With a contract or promissory note, you can avoid many of these problems by ironing out certain details, including:

  • Repayment terms
  • Interest rate (if any)
  • Amount needed
  • Purpose of the loan

Before borrowing money, consider who you’re planning to ask and their financial situation. Some people are in a better position to help out financially. Others may want to but could end up burdened or stressed if they lend money.

Regardless of who you ask, creating a contract and treating the borrowed amount like a real loan can be beneficial for everybody. Not only can it set realistic expectations from the get-go, but it can also prevent confusion or unneeded stress.

Sign a Loan Contract 

When it comes to borrowing money from a friend, creating a contract may be the last thing you want to do. After all, everyone wants to believe the best about the people close to them. They don’t want to have to plan ahead in case they need to take legal action. That’s why many loan agreements between friends are little more than a handshake or informal IOU.

But even if you have the best intentions, things don’t always go according to plan. Any number of things could come up that delay payment or keep you from repaying the borrowed money at all. This could be anything from a surprise bill or a hike in rent to sudden unemployment.

No matter how valid the reason, the person who lent the money could end up in a tricky situation if they don’t get their money back. To avoid this, treat these loans like any business loan. This means drafting a contract that details the exact loan terms and what will happen if these terms are not met.

Best case scenario, this will simply give everyone involved peace of mind. Worst case, the contract will ensure the lender still gets what they’re owed. Unlike a handshake or verbal agreement, it will also make the loan legally collectible in small claims court.

The good news is, creating a loan contract for money borrowed from friends isn’t difficult. There are even free templates online to make it even easier.

How to Write a Loan Contract

Every loan contract should include a few basic terms and concepts. This includes:

  • Full legal names of the borrower and lender
  • The original amount borrowed (principal)
  • The interest rate or annual percentage rate (APR)
  • Repayment terms (ex. monthly or biweekly installments)
  • Expected payoff period (in months or years)
  • The original date of the loan

Here’s the general process of creating a loan contract between friends or family:

  • Set up a meeting, ideally in person, between the borrower and lender. If this isn’t possible, correspond over email so there’s a written record of everything
  • Discuss the borrower’s financial situation and needs. This should include how much they need to borrow and why
  • Agree on the interest rate and repayment schedule
  • Discuss late payments and other penalties. Including this can help keep the borrower on track with payments
  • Ask about using a loan administration company. This can help the borrower build or repair their credit
  • Set spending limitations. Some contracts may also include any limitations on how the money is spent. This is useful in cases when the borrower needs a large sum for a very specific purpose

Composing the Personal Loan Agreement

A personal loan agreement is a legally binding contract between two parties. It is generally created by a bank, but it can also be drafted between friends and family members. These types of agreements and contracts are especially useful in cases when the borrower needs a large sum of money. That is, if they’re borrowing thousands or tens of thousands of dollars.

After the lender and borrower both sign the personal loan agreement, the next step is to get it notarized. This isn’t always necessary, but it can make the contract more legitimate. This, in turn, could help prevent future conflicts between the borrower and lender.

The contract should include the following information:

  • Borrower’s full name and address
  • Lender’s full name and address
  • The total amount of the loan (principal)
  • City, state and county where the loan was granted
  • Date the loan is effective (often the same as when the funds are disbursed)
  • Whether there will be any interest charges and at what rate
  • Repayment schedule and type (lump-sum payment, monthly or weekly installments, due on demand, etc.)
  • Payment amounts (fixed or variable)
  • Payment due dates (flexible or not)
  • Date final payment is due
  • Any penalties (ex. late fees)
  • Any other fees (ex. origination fees)
  • Consequences for if the borrower defaults
  • Any acceptable modifications during the repayment schedule (ex. payment dates or owed amount)

If the borrower cannot follow through on the personal loan agreement, the friend or family member who lent the money can take them to court. When that happens, the contract serves as proof that the agreement was made. It also allows the lender to engage in debt collection or wage garnishment against the borrower.

Be sure to keep the lines of communication open. This can help prevent any surprises from occurring. It can also reduce potential stress between both parties.

Free Promissory Note Templates

A contract between friends is still a legally binding document. However, it’s not always necessary to consult a law firm or get legal advice to set up a promissory note. There are plenty of free loan agreement templates online.

  • LegalNature: LegalNature has a clear-cut template for creating a promissory note for money, services and goods. It also has helpful resources on what to include, the general structure and why you should use one.
  • RocketLawyer: RocketLawyer makes it easy to draft a loan agreement in three simple steps.
  • LawDepot: With LawDepot, it’s simple to create a loan contract from either the borrower’s or the lender’s side.

Is a friend or family member asking you for a loan? Here are some ways to handle it.

Learn the Tax Consequences

There are certain tax consequences for both the borrower and the lender, even in personal loan contracts. These consequences mainly depend on whether the loan has interest or not.

  • Loans with interest: Any interest-bearing loan between friends is treated the same as one between a third-party institution. The person receiving interest payments (lender) must report them to the IRS on their next tax return. Depending on the amount received, it could be considered taxable income. The borrower may be able to get a tax deduction if they use the loan for business purposes.
  • Loans without interest: Even if there’s no interest, this type of loan may be considered a gift to the other person. In this case, both the lender and the borrower could be required to pay gift taxes at the applicable federal rate.

Most loans between friends and family members are exempt from harsh taxation. This does depend on the amount borrowed, though, as well as the purpose of the funds. For example, someone can give up to $15,000 a year without having to worry about gift tax.

The Most Popular Reasons for Borrowing Money From Family or Friends

There are many reasons why a person might consider borrowing money from a friend or family member. The most popular ones include:

  • Creating a small business startup
  • Buying a home or property
  • Need for a security deposit
  • Minimizing the cost of student loans
  • Unexpected unemployment
  • Sudden illness (individual or family)
  • Purchasing a vehicle without a high-interest auto loan
  • Buying a big-ticket item like a computer or other technical equipment
  • Paying for a family vacation
  • Buying an engagement ring

Other Types of Loans to Consider

If you’d rather not borrow money from a friend or deal with a personal contract, here are a few other options to consider:

  • Personal loan: These are generally unsecured loans that are offered based on the borrower’s credit score, DTI, income and so forth. They often come with monthly installments and an APR of 6% to 36%. The interest rate mainly depends on the borrower’s credit score.
  • Credit card balance transfer: If you have high-interest credit card debt, consider a balance transfer to a new card. These cards typically start accruing interest right away, so keep this in mind. Your credit score will help determine the interest rate.
  • Cash advance app: For those who need a small amount of money quickly, a cash advance app like Earnin could be a temporary solution. These apps let you borrow a few hundred dollars against your upcoming paycheck. They are usually free and don’t come with interest charges.
  • Peer-to-peer (P2P) lending: P2P lending lets individual borrowers and investors work together without using a third-party institution. It’s available through platforms like Prosper or Upstart.

Before choosing any of these options, make sure you have a clear reason for borrowing the money. Also, make sure the loan fits into your budget to avoid potential penalties or unmanageable debt.

The Bottom Line

Borrowing money from a friend or family member is a convenient way to fund a project or startup, pay for unexpected bills and more. It can also let you avoid high-interest loans and skip the credit check.

It does come with some potential pitfalls, though, especially if the borrower has trouble repaying what they owe. To prevent undue stress in the relationship and keep everyone on the same page, draft a contract on the loan. Keep aware of any tax implications to avoid any financial surprises.

FAQs

How Much Interest Should I Charge a Friend for a Loan?

That depends. Ask yourself if you want the money to be considered a gift under the IRS guidelines or a loan. The IRS regularly posts AFRs, or Applicable Federal Rates, showing how much the interest rate should be to avoid tax complications. The percentage rate changes each month, so check the latest guidelines before offering a loan.

What is a Balance Transfer Credit Card?

A balance transfer credit card is a credit card that lets you transfer debt, typically from another credit card, to it. These cards usually come with a transfer fee that’s 3% to 5% of the transferred amount. The main reason people use a balance transfer card is that they typically have a 12- to an 18-month introductory period of 0% or low interest. If you can pay off the balance during this period, you can save on interest charges and focus on paying off the debt.

What is The Statute of Frauds?

The Statute of Frauds is a common law concept that requires contracts to be executed in writing. It primarily applies to promises made in regards to things like marriage, the sale of land or goods above a certain value and loans between friends. If a contract under this statute is breached, then the lender can use it as a defense in court to try to collect what is owed.

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