Lending Money to Family or Friends

The instinct is to keep it casual. Don't. A written promissory note is the single best thing you can do to keep the relationship and the money both intact.

Why a written note matters more, not less, with people you know

Family money arguments do not start with malice. They start with a missed payment, a vague repayment conversation, or a "we never really agreed on that" moment six months in. A promissory note takes those moments off the table. It writes down the principal, the interest rate, the payment schedule, what happens if the borrower is late, and how the loan ends.

The note is also your only protection if things go sideways. A friend who stops paying can be sued on a promissory note in small claims or civil court. A friend who "borrowed" with no paperwork is, in the IRS's view, just someone you gave money to.

The IRS angle most lenders forget

The IRS draws a sharp line between a real loan and a gift. Three things matter:

1. The Applicable Federal Rate (AFR)

For loans above $10,000, the IRS expects you to charge at least the AFR for your loan term. If you charge less (or 0%), the IRS imputes interest at the AFR, treats the imputed interest as taxable income to you, and treats the same amount as a gift to the borrower. The AFR is published monthly in three tiers (short-term, mid-term, long-term) and is generally well below market rates. Lock in the rate at origination - it stays for the life of the loan.

2. The $10,000 exception

Loans of $10,000 or less are generally exempt from imputed interest, as long as the borrower does not use the money to buy income-producing assets. This is the easy zone for casual family loans.

3. The annual gift-tax exclusion

If you forgive part of the loan or never collect, the forgiven amount is treated as a gift. As long as you stay under the annual exclusion ($18,000 per recipient in 2024 and 2025; $36,000 from a married couple), no IRS reporting is needed. Larger amounts trigger Form 709 (but no tax due until you cross the lifetime exemption of $13.61M).

The conversations to have before signing

Principal amount. The exact dollar figure being lent.
Interest rate. AFR or higher. Use our Usury Limit Checker to make sure the rate is also under your state's legal cap.
Repayment schedule. Monthly, quarterly, or balloon. Pick a real schedule that matches the borrower's cash flow.
Late fees. Even a small fee creates structure. Reasonable late fees are enforceable in most states.
Maturity date. When the loan must be paid in full.
Collateral. If any. A car, a piece of equipment, or other property pledged as security.
Default and acceleration. If the borrower misses X payments, you can demand the entire balance.
Prepayment. Can the borrower pay early without penalty? (Usually yes for family loans.)

What note type should you use?

Pick based on the real repayment plan, not what sounds nicest.

Installment Note (regular payments) Secured Note (with collateral) Demand Note (open-ended)

Installment Note - fixed regular payments (monthly, quarterly) over a set term. Cleanest for most family situations. Works like a car loan.
Secured Note - uses collateral. Best for larger loans where you want a real fallback. The borrower pledges an asset; if they default, you can take it through your state's repossession process.
Unsecured Note - no collateral. Faster to set up, less protection. Fine for smaller amounts where you have to accept the risk.
Demand Note - no fixed schedule; lender can demand full repayment with proper notice (typically 30 days). Useful when timing is uncertain.

Common mistakes to avoid

Verbal "loans." Almost always end up reclassified as gifts by the IRS. Write it down.
0% interest on amounts above $10,000. Triggers imputed interest. Use the AFR.
Vague repayment terms. "Pay me back when you can" is not a loan. Pick a schedule.
No paper trail on payments. Use bank transfers (not cash) so payments are documented.
Forgetting to record interest income. Interest you receive on the loan is taxable income to you. Report it.
Mixing the loan with gifts. If you also want to give the borrower money for their birthday, do it as a separate transaction. Don't bury it in a "discount" on the loan.

Bottom line

The promissory note is not a sign that you don't trust your family. It is a sign that you respect the loan enough to make it real. Real loans get repaid more often, the IRS leaves you alone, and the next Thanksgiving doesn't come with a side of resentment.

Frequently Asked Questions

Do I really need a written promissory note for a family loan?

Yes. Even a simple written note removes ambiguity about the amount, repayment schedule, interest rate, and what happens if the borrower cannot pay. Without a note, the IRS may treat the transfer as a gift, you have no enforceable claim if things go wrong, and family disputes about "what we agreed" become impossible to resolve. The note protects both sides.

Can I make a 0% interest family loan?

Sometimes, but watch the IRS rules. The IRS requires loans above $10,000 to charge at least the Applicable Federal Rate (AFR) for the loan term, otherwise it imputes interest income to the lender and treats the imputed amount as a gift to the borrower. Loans of $10,000 or less are generally exempt from imputed interest if the borrower does not use the money to buy income-producing assets. Check the current AFR at irs.gov before setting your rate.

What is the Applicable Federal Rate (AFR) and where do I find it?

The AFR is the minimum interest rate the IRS expects on a private loan to avoid imputed-interest treatment. It is published monthly by the IRS in three tiers: short-term (loans of 3 years or less), mid-term (3 to 9 years), and long-term (over 9 years). Find current rates by searching "IRS AFR" plus the current month. The rate locked in at loan origination applies for the life of the loan.

Should I take collateral from a family member?

For larger loans, yes. A secured note (where the borrower pledges a car, equipment, or other property) protects you if the borrower cannot pay. It also signals seriousness on both sides. For smaller loans where the relationship is the real "collateral," an unsecured note is fine. Think about it this way: would you rather have an awkward conversation about repossessing a car, or no recourse at all?

What lengths and structures work for a family loan?

Three common structures: (1) Installment note - fixed monthly or quarterly payments over a set term, like a car loan. Cleanest for most family situations. (2) Demand note - lender can call for full payment with notice (often 30 days). Useful when timing is uncertain. (3) Balloon note - small periodic payments with the full balance due at a defined date. Best when the borrower expects a future inflow (sale of property, bonus, inheritance). Pick the one that matches the real repayment plan.

What if the family member cannot pay?

Three escalating options. First, modify the note in writing - new schedule, lower payment, extended term. Document the modification both parties sign. Second, if you have collateral, the secured note lets you take possession through your state's repossession procedure. Third, if there is no collateral and modification is not working, you can sue on the note in small claims court (up to your state's limit, typically $5,000 to $25,000) or regular civil court for larger amounts. Statutes of limitation apply, so do not wait years to act.

How does forgiving a family loan work tax-wise?

Forgiving a loan is treated as a gift in the year of forgiveness. As long as the forgiven amount per recipient stays under the annual gift-tax exclusion ($18,000 in 2024 and 2025, or $36,000 from a married couple), no IRS reporting is required. Forgive larger amounts in installments across years to stay under the threshold, or accept that you will need to file Form 709 (no tax due unless you exceed the lifetime exemption of $13.61M).

Can I deduct the loss if my family member never pays back?

Possibly, as a non-business bad debt. The IRS allows lenders to claim a short-term capital loss for a non-business bad debt that becomes "totally worthless" in the tax year. Requirements: a bona fide debt (a real loan, not a disguised gift), reasonable collection efforts, and totally worthless status (not just late). The written promissory note is the single most important piece of evidence. Without it, the IRS will likely treat the original transfer as a gift and disallow the deduction. Talk to a CPA before claiming.