Loans: The Essential Guide to Lending Money

Last Updated July 4, 2024

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Kyle Adam

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Sarah Ure

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Rebecca Koehn

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Lending money always comes with risks, but lending to a family member or friend comes with even more challenges. In the worst-case scenario, you can lose your money and damage an important relationship.

You must understand the basics of lending money and the various ways you can protect yourself and your finances.

In the following guide, we'll break down everything related to lending money, including lowering your risk, using Loan Agreements, Promissory Notes, and more.

Lending money comes with risk, but you can reduce that risk by taking the appropriate precautions.

1. Only loan to people you trust

Any time you lend money, you assume some level of risk. You are surrendering your money to someone else and depending on them to return it. However, you can lower your risk level if you only lend money to people you trust.

But what makes a person trustworthy?

You might trust a person based on previous positive interactions. Or, if you and a borrower have a mutual acquaintance, you may trust them based on the acquaintance's opinion. Ultimately, trust is something you have to define for yourself.

When it comes to personal loans, many people only trust family and friends as borrowers. But before you lend to a loved one, consider how the loan may impact your relationship with them.

2. Make sure the borrower knows the loan is not a gift

Before you provide someone with a loan, ensure they understand that the money is not a gift. This understanding is essential in getting your money back and maintaining a good relationship with the borrower.

In addition, when it comes to taxes, loans and gifts are treated very differently. Gifts are subject to a gift tax.

Gift tax is a federal tax on transfers of money or property to other people while getting nothing (or less than full value) in return. According to the IRS, you can only gift an annual amount of $15,000 per individual without having to pay gift tax. So, if you loan someone over $15,000 and they don't pay it back, it can be considered a gift and create tax complications.

3. Inspect the borrower's financial statements

If you don't have a thorough grasp of someone's financial stability, you can ask to see their financial statements before you lend them money. Understanding someone's current financial status allows you to evaluate the risk of lending to them.

When a borrower creates a Personal Financial Statement, they disclose their assets and liabilities. Their assets may include cash, bank and brokerage accounts, savings, and investments. Their financial liabilities may include credit card debt, car loans, mortgages, and unpaid taxes.

Subtracting a borrower's liabilities from their assets gives you an idea of their net worth and helps you decide if lending to them is a smart financial decision.

4. Limit the loan amount to what you can afford

If you can't afford to lend someone the amount of money they are asking for, that's okay. If you have to reach into your retirement savings, you may want to consider if risking your future income is in your best interest. Similarly, if you have to borrow money yourself to lend it to someone else, reconsider if it's worth it.

You have to prioritize yourself and protect your interests when lending money. If you can only afford to lend a certain amount, set a limit and communicate it to the borrower. If your limit doesn't work for them, they can find an alternate lender, such as another person or a bank. You have no obligation to lend someone money and should not feel pushed or coerced into doing so.

Remember that choosing to lend someone money is a financial decision—not an emotional decision.

5. If you deny someone a loan, be careful of cosigning loans

If you aren't willing or able to loan someone money, they may ask you to cosign a loan for them. A cosigner agrees to be held responsible in the event that the borrower can't pay back a lender or breaks the terms of their loan. You should be extremely cautious before cosigning a loan for someone else, as it comes with high risks and can impact your credit score.

Established lenders, such as banks or credit card companies, may require a borrower to have a cosigner if the borrower:

• Has poor credit or no credit history
• Doesn't meet income requirements
• Is self-employed
• Already has high debt

Private lending situations, such as loans between family members or friends, can also involve cosigners. However, be very careful before you agree to cosign a loan for someone.

When you're a cosigner:

• You have to allocate time and effort: When you're a cosigner, you should track the borrower's payments to better protect yourself. You can ask to see proof of the borrower's bank account transfer or proof of payment to ensure they are making the loan payments on time.
• You are liable for the full loan amount and can be sued: As a cosigner, you agree to be held responsible if the borrower can't pay back a loan. Therefore, the lender can sue you first if the borrower defaults on payments.

When you're loaning money, these are things you need to do to mitigate your risk, ensure timely repayment, and protect your relationship with a borrower.

1. Get it in writing!

When lending money, a written Loan Agreement or Promissory Note is your best friend. Even if you're loaning money to a friend or family member, it's always a good idea to create a written contract rather than rely on a verbal agreement.

Some people lend money in good faith without putting pen to paper. However, this type of arrangement can lead to problems if the borrower doesn't hold up their end of the deal. Similarly, if you and a borrower remember the terms of the verbal agreement differently, there's no document to reference.

Generally, a Loan Agreement will include the following information:

• Your information
• The borrower's information
• The loan amount
• Interest and late fees
• A repayment plan
• Collateral terms

When it comes to taxes, documenting a loan with a Loan Agreement can also be beneficial. For example, having proper documentation can be helpful if a borrower doesn't repay a loan and you want to deduct the lost amount from your personal income taxes.

Benefits of a Loan Agreement

Creating a Loan Agreement and having a paper trail of a loan protects your grounds for legal recourse if the borrower doesn't repay you. In addition, there are other benefits of creating a Loan Agreement. When you create and execute a Loan Agreement properly, it:

• Documents the borrower's obligation to repay the loan
• Discourages the borrower from claiming anything that contradicts the agreement's terms
• Outlines a repayment plan and when it begins
• Prevents misunderstandings

Use a Promissory Note for less formal agreements

If you want something less formal than a Loan Agreement, use a Promissory Note to ensure you still have written documentation for the loan. Often family members use Promissory Notes when lending money to one another.

Much like a Loan Agreement, a Promissory Note documents the legally binding promise that a borrower makes to pay back a loan. Unlike an IOU that simply acknowledges a debt amount, a Promissory Note goes into detail about the consequences of failing to repay a loan.

Generally, a Promissory Note will include the following information:

• Your information
• The borrower's information
• The loan amount
• Interest and late fees
• A repayment plan
• Collateral terms

Although perceived as less formal than a Loan Agreement, a Promissory Note is still a legally enforceable contract that can protect you if a borrower doesn't pay you back.

2. Choose an appropriate amount of interest

Sometimes for borrowers, one of the perks of borrowing money from a family member or friend is that they will charge less interest than a bank or other money-lending institution. Furthermore, many lenders don't want to charge any interest for family or friends.

However, depending on your lending situation, charging interest may prevent unnecessary tax complications.

The IRS (Internal Revenue Service) prefers that you charge interest when lending substantial amounts. Providing interest-free loans means that the lost interest income can't be taxed. Therefore, the IRS prescribes various interest rates that you can use to calculate the interest on below-market personal loans. These rates are known as AFR (Applicable Federal Rates) and represent the absolute minimum market interest rate you should charge a borrower.

When it comes to personal loans, specifically loans above $10,000, you can reference the AFR to determine how much interest you should charge. Failing to charge interest could complicate your taxes.

For example, even if you don't collect interest on a loan, the IRS can require you to pay income taxes on the earned interest income it believes you received. In this case, the interest is based on the AFR at the time you provided the loan. By charging interest at the recommended rate of the IRS, you can avoid these possible tax complications.

3. Set an appropriate repayment timeline

One of the best ways to get your money back on time is to set up a repayment schedule.

Maybe you want your borrower to pay you back in one lump sum on a specific date, or maybe you want smaller monthly payments for a year. Either way, setting up a plan for you and the borrower to follow establishes your expectations and obligations.

When you create your Loan Agreement or Promissory Note using our templates and outline the repayment terms, we provide you with a built-in Amortization Schedule. An Amortization Schedule is a plan that outlines periodic loan payments. If you and your borrower agree to a different schedule, you can either update your agreement or create a separate Amortization Schedule.

Furthermore, you must decide if there will be penalties for late payments. Applying a late penalty, such as a fee or interest rate increase, encourages timely payments. In addition, as the lender, you decide whether or not you want to apply the late penalty. For example, if your borrower is one day late on a payment, you don't have to apply a penalty if you don't want to.

4. Consider asking for collateral or a Deed of Trust

Want to lower your risk even more? If so, you can ask a borrower for collateral before providing them with a loan.

Collateral

Collateral is an asset or property that the borrower offers up to protect your financial interests. For example, a borrower may be willing to offer their car as collateral. If they fail to repay the loan in full, you can seize the car to reimburse yourself.

Generally, you don't get immediate control of the collateral when the loan is given. Only when a borrower doesn't repay the loan, you can petition to take ownership of the car and sell it to reduce your loss. Asking for collateral is most useful when there is a high risk the borrower will default, or you're lending a substantial amount.

If you don't secure a loan with collateral, you need to go to court before seizing any of the borrower's assets.

Deed of Trust

If a borrower is using a personal loan to help purchase or refinance real property consider the advantages of securing the loan with a Deed of Trust.

A Deed of Trust secures a loan for real property and protects your interests as the lender. A Deed of Trust can only be used for real property, such as land or a house.

When you and a borrower use this type of deed, a property title is transferred to a neutral third party until the borrower pays off the loan. Once repayment is complete, the property title is transferred from the third party to the borrower. If the borrower doesn't pay you back, a Deed of Trust can help ensure you are compensated for your financial loss.

If worse comes to worst and a borrower won't repay you, you can send them a Demand Letter and, if that doesn't work, file a claim with small claims court.

1. Send a Demand Letter

A Demand Letter is a written request that you send to demand payment or action from a borrower. The goal of a Demand Letter is to resolve an issue without going to court.

In general, a Demand Letter should include the purpose for the letter, the request for payment by a certain date, and threaten legal action if the borrower doesn't remedy the situation. You may also attach your Loan Agreement or Promissory Note to the Demand Letter to help prove your claim and remind the borrower of their obligations.

Once you create a Demand Letter, you have to deliver it to the borrower. You can:

• Deliver it in-person
• Hire a lawyer to deliver it on your behalf
• Ask a friend or family member to deliver it on your behalf
• Send it by registered mail

After a borrower receives a Demand Letter, they may respond in one of the following ways:

• Comply with your demand: Often the threat of legal action is enough to prompt payment or action from the borrower.
• Make a counteroffer: A borrower may suggest setting a different date for payment, allowing them time to acquire the money. Although not ideal, giving the borrower more time could be the simplest solution.
• Ignore your letter: If you do not receive a response by the due date (the end date you included in your letter), you can contact the borrower to ensure the letter was received, send a second letter, or file a claim in small claims court.

2. File with small claims court

Small claims court allows you to seek resolution for minor disputes at a low cost. It has less complicated rules and procedures than other state and federal courts. States have varying guidelines for filing in small claims court.

The limit that you can claim is normally between $2,500 and $15,000. For example, in California, claims are limited to $10,000 for individuals and $5,000 for businesses.

Additionally, states have different rules for allowing you to bring legal representation into small claims court. However, even if you're permitted to be represented by a lawyer, it may not be financially worth it because lawyer fees are so expensive. Often, lawyers charge too much compared to the smaller amounts involved in small claims cases.

Loaning money can be tricky, especially when you have to navigate a personal relationship simultaneously. When you're considering lending someone money, remember that it's not an emotional decision.

To protect your interests, think of lending money as a financial transaction and decide if it's the right move for your finances.

If you are going to lend money, never loan more than what you can financially handle, discuss the terms with the borrower, and always get the loan in writing in case anything goes wrong.