Promissory Note for Personal Loans

Promissory Notes: Personal Loans to Friends and Family

Protecting yourself with a promissory note when making loans to family and friends.

It is common to loan money to a family member or a friend when in need of it and seal to this deal is often the word or a handshake. Unfortunately as time passes, memories fade and lead to disagreements. Protect yourself by making an promissory note that details the terms of this loan agreement.

Promissory Note Basics

A promissory note is a promise to pay back money to someone. It is a written evidence of the debt amount and the terms decided at the time of loan giving. This note also includes repayment schedule, interest rate (if any) and any other terms between them.

The three important questions to start and decide upon are:

  • Amount of money to loan
  • If interest to be charged then how much
  • The repayment schedule

Should You Charge Interest?

Charging interest to a friend or a family member is often considered as being ungenerous by many people but this view is often based upon a misconception about the function of interest, which is to reasonably compensate the lender for the use of his money.

For example: Let us suppose if Aashish lends Ketan the amount of 2,50,000 for a year (interest-free). If Aashish puts his money in bank he would earn interest for that time period. But by giving the money interest-free to Ketan he bears the cost of lending the money to Ketan. Nevertheless, when lending a relatively small amount to friends or family, you may prefer to lend the money interest-free.

Interest-free loans and IRS: The IRS on the interest-free loan can “impute” interest on the loan. Let us assume that you have earned the interest and require it to report as a taxable income but for most of the personal loans that won’t be a problem. The uncharged interest can be treated as tax-free gift as long as the total amount given to the borrower is less then the gift-tax exclusion.

Types of Promissory Note Repayment Plans

You and the borrower should agree on a plan for repaying the loan. Here are some options:

Installment Payments in Equal Amounts

In this payment plan the borrower makes equal monthly or yearly payments for some specified recursive period of time which is until the loan is paid off completely.

If you are charging interest then the part of each payment goes towards the interest and other towards the principal amount. When the last payment is made the loan or the principal amount together with the interest is fully paid.

One can calculate the interest depending upon the interest rate and time over which the payments would be made. There are various online interest calculators available to calculate the amount of each payment.

Lump Sum Payment of Principal and Interest

In many cases the loans given to friends and family are often paid back all at once with interest as decided on the promissory note. This payment is inclusive of the entire principal amount together with the interest.

Balloon Payments

This method of payment is rarely used in loans towards family and friends, in this plan the borrower makes equal payments for a period of time (the payments can cover interest and principal, or interest only). These payments pay some amount of the loan but not complete and hence the last payment is made by the borrower which is a large payment known as the balloon payment to complete the principal and the remaining interest payment.

Securing the Loan with Property

Securing loan with the borrower’s property such as computer, car etc as guarantee payment scheme. If the borrower fails to pay the lender then the lender gets back the property.

Most personal loans are unsecured. However, if you do want security for your personal loan, consider what property will be the security and what documents you need.

  • Tangible personal property.
  • Real estate.
  • Intangible personal property.

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