How to lend money to family

The first decision is the one most families skip. Money that changes hands with a vague “pay me back when you can” is neither a gift nor a loan, and that ambiguity is what causes trouble later. The borrower remembers it one way, the lender another, and a sibling who was not in the room remembers it a third way.

If you can afford to never see the money again and would not resent that, make it a gift and say so in writing. If you expect repayment, make it a loan and put the terms in writing. Either choice is fine. The mistake is leaving it undecided.

The distinction also matters to the IRS. A gift above the annual exclusion may require a gift-tax return. A loan does not, as long as it is a real loan with a rate and a repayment schedule. Treating a gift as a loan, or a loan as a gift, invites questions at tax time and at estate time. See what interest rate to charge on a family loan for the rate rules.

Five things need an answer. Settle them in one conversation, then write them down.

• Amount. The exact figure being lent, in one advance or in stages.
• Rate. An annual interest rate, fixed for the life of the loan. Zero is a choice with tax consequences, covered below.
• Term. How long the borrower has to repay. Three to five years is common for a car or a home deposit. Shorter terms mean larger payments.
• Schedule. Monthly payments of a fixed amount are the easiest to keep. A single payment at the end is easier to promise and harder to make.
• What happens if a payment is late. A grace period, a late fee, and what the lender may do if payments stop altogether.

Run the numbers before you commit. A loan of $25,000 at 6% over 36 months costs the borrower about $760.55 a month and about $2,380 in total interest. If that payment does not fit the borrower’s budget, lengthen the term or lend less. Agreeing a payment the borrower cannot make is the most common way a family loan fails. The loan calculator shows the full schedule for any combination.

A promissory note is a short document in which the borrower promises to repay a stated amount on stated terms. It does not need to be long. It does need to be signed.

The note does four jobs that a conversation cannot.

• Clarity. Both people can read the same terms a year from now. Memory fades. Paper does not.
• Tax. The IRS treats a loan as a loan only if it looks like one: a written note, a rate, a schedule, and payments that actually happen. Without those, a lender who later writes off the balance may be unable to claim the loss, and the original advance may be recharacterized as a gift.
• Estate. If the lender dies with the loan outstanding, the note tells the executor what is owed and by whom. Without it, the balance is a matter of argument between heirs.
• Other siblings. A note shows that the money was lent, not given, which answers the question before it is asked.

The guide to what a promissory note is lists each clause. For a loan secured by a car or a home, the note is paired with a separate document that creates the security interest.

You may charge any rate the borrower agrees to, within your state’s usury limit. Charging nothing is also allowed, but it is not free of consequence. Under Internal Revenue Code section 7872, a loan at less than the applicable federal rate is treated as if interest at that rate had been charged, with the foregone amount treated as a gift from lender to borrower and as imputed interest income to the lender.

There are exceptions for small loans, which are explained in the rate guide. For most family loans above the exception thresholds, the simplest answer is to charge at least the AFR for the month the loan is made and the term you have chosen. The IRS publishes the rates monthly. They are usually well below what a bank would charge, so the borrower still gets a favourable deal and the lender avoids the imputed-interest rules entirely.

Whatever rate you choose, write it in the note as a fixed annual percentage. Do not leave it to be agreed later.

Send the money in a way that leaves a trace: a bank transfer or a check, not cash. Note the date the funds were advanced. Interest runs from that date, and the repayment schedule is built from it.

Keep the signed note, the record of the transfer, and the schedule together. If the loan is in NoteHouse, the lender marks the loan as funded with the date and the disbursement becomes the first entry in the loan’s ledger. Either way, the point is that a stranger reading the file could reconstruct what happened.

Most family loans have at least one late payment. The note should say what happens, so that the lender is applying a rule rather than making a decision in the moment. A short grace period and a modest late fee are common. Charging the fee is optional; having the right to charge it is what matters.

If payments stop, talk first. The usual causes are a job loss or an unexpected expense, and the usual fix is a revised schedule: lower payments over a longer term, or a pause with interest still accruing. Put the change in writing as an amendment to the note, signed by both, so that the record stays accurate.

If the loan will never be repaid, the lender has two honest options. Forgive the balance, which is a gift and may need a gift-tax return if it exceeds the annual exclusion. Or treat it as a bad debt, which for a personal loan is deductible only as a short-term capital loss and only if the debt was genuine and has become wholly worthless. The signed note and the payment history are what make either option defensible. See when a borrower pays late for the steps in order.

A loan is a ledger: the amount advanced, interest as it accrues, each payment, and the balance after it. Keeping that ledger current is the difference between a loan that closes cleanly and one that ends in a dispute over how much is still owed.

• Record each payment on the day it arrives, with the amount and how it was paid.
• Have the other party confirm it. A payment both people have acknowledged is not argued about later.
• Apply each payment the same way every time: fees first, then interest due, then principal.
• When the borrower wants to pay off early, issue a payoff statement giving the exact amount owed on a specific date.

A spreadsheet can do this if someone maintains it. NoteHouse keeps the ledger for both parties, with each payment recorded by one side and confirmed by the other, so neither person has to be the bookkeeper.