Many people turn to friends and family for credit when they buy a large asset or start a business. Loans to family and friends are a high risk endeavor with little to gain for the lender other than the satisfaction that comes with helping someone you know. When it comes to borrowing money, even to family and friends, a common refrain that you will hear over and over again is "get it in writing".
There are good reasons to get a loan agreement, sometimes called a promissory note, in writing, but you may have other questions about lending money to people you know. Here are some common questions and answers about lending money to family and friends.
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Is it legal to borrow money?
Yes it is. It is legal to borrow money and when you do so the debt becomes a legal obligation on the borrower to repay it. You can take legal action against your borrower if you default in a small claims court. This may seem harsh, but it's important to understand it in advance. A loan between relatives has the same legal weight as a bank loan.
When loaning money to a friend or family member, in case there is a conflict or misunderstanding, you may want to get the details in writing and have them signed by all parties. Having just an oral understanding and handshake may not be enough to prove the specifics of your agreement. A signed written contract is far better than a handshake.
Can I loan a friend and get interest?
Yes you can, but the tax implications can be difficult and complicated. You would have earned interest on the money had you kept it in an interest bearing account, and that's a good reason to charge interest. However, casual lenders could inadvertently experience tax problems if they fail to structure their loans wisely, receive all the details in writing, and have the written agreement signed by lenders and borrowers. Ask a lawyer if you'd like to finalize your loan agreement to avoid costly mistakes in the future.
Should I avoid borrowing money because of potential legal disputes?
It all depends. Consider your financial situation and goals:
- Can you afford to tie up this money?
- If other lenders have refused the borrower, do you really want to take the risk? What if the borrower encounters unexpected challenges?
- Are you and other family members ready to take legal action in the event of a default?
- Are you ready to cancel your borrower's debt in order to keep the peace?
If losing this amount of money would cause you serious financial harm, you can choose to say so and avoid taking out the loan. If you go ahead, you may want to write a note on terms that both parties can agree to and abide by.
How can I make sure I get paid back?
While there are few guarantees in life, here are some tips that can increase the chances of getting you paid back in full.
Tip 1: Write the terms in writing.
You can use a legally binding and easy-to-complete loan agreement called a promissory note to record the details of your loan. Of course, having a spoken promise between friends is easier and emotionally gentler, but the problem arises when one or both of the parties cannot remember the terms in a year or two. A written agreement prevents an uncomfortable debate later.
Tip 2: Establish all important contract terms.
Consider including the following:
- Names and addresses of the contracting parties
- Loan amount (principal)
- Interest rate
- Refund policy, including late fees or penalties
- Signature lines
The repayment conditions can be based on the circumstances of the parties. For example, two smaller payments per month might work better for the borrower. Alternatively, if the borrower expects a significant financial upturn such as a tax refund, a lump sum repayment may make sense. In either case, you may want to clearly state the due date.
You can also specify the collateral for the loan and, if applicable, indicate that the loan obligation is transferable to a third party.
Tip 3: Indicate your recourse if the borrower has a default.
If the borrower defaults or fails to pay their debts, you can:
- Modify the terms of the agreement to reflect changes in circumstances
- If necessary, take collateral to secure the loan
- Contact a small claims court for a verdict
A few final points to note
Rocket Lawyer's promissory note allows you to cover the legal bases, including loan amount, repayment, and default provisions.
If you're having trouble collecting repayments, check out these tips on collecting personal debt. You may need an attorney to renegotiate the loan terms, collect part of the debt in a settlement agreement, or help the borrower obtain a debt consolidation loan.
Do you need case-specific advice? Ask an attorney if your situation calls for affordable, quality legal services.
This article contains general legal information and not legal advice. Rocket Lawyer is not a law firm or a substitute for a lawyer or a law firm. The law is complex and changes frequently. For legal advice, please contact a lawyer.