A Lender’s Guide to Loan Agreements

LoanBack.com on 02/16/2011

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If you have the means and desire to do so, there’s nothing wrong with lending money to friends or family. But for these types of personal loans, there’s a right way and a wrong way to lend. Lending money the wrong way can damage your finances and your relationship.

In almost every respect, a personal loan to a friend or family member is the same as a loan from a bank. The main difference is that you, the lender, are a friend or relative. But don’t let your personal relationship with the borrower affect the formality or wisdom of your loan agreement. A handshake or verbal agreement can be quickly forgotten or misinterpreted, which can lead to personal acrimony and poison the relationship down the road.

The best way to prevent future disputes is for both parties to negotiate and sign a loan agreement (or promissory note) and track the performance of the loan using a service like LoanBack. When negotiating the loan there are several components to consider:

Loan Purpose

The borrower should be clear regarding the loan’s purpose. Will the money be used to finance the purchase of a car, pay off other high-interest debt, put a down-payment on a house, or some other purpose? Before writing your check, make sure you know and are comfortable with how the money is going to be used.

Loan Amount

Be sure the borrower has done their homework and knows exactly how much money they require for the loan purpose. The loan amount (or principal) should be clearly stated in the loan agreement. The loan amount is also required to set up the amortization or repayment schedule.

Loan Interest Rate

Be realistic about interest rates. Some lenders want to help a friend or family member by providing a loan with an extremely low interest rate, or even no interest at all. However, a fair interest rate is a key component of any loan. If you charge little or no interest, the IRS might consider the loan a gift and require you pay taxes on the amount. On the other hand, if the interest rate is prohibitively high it will be harder for the borrower to repay the loan and might even violate your state’s usury (excessive interest) limits.

Depending on the loan purpose and amount, there are different benchmarks you can use when setting up your personal loan. For more information check out “How to Determine the Interest Rate on a Personal Loan”.

Loan Term

The loan term is another area where well-intentioned lenders can run into trouble. The loan term is the amount of time the borrower has to pay back the loan measured in months or years. Just as it’s not a good idea to charge too little interest on your loan, it’s also not a good idea to have an open-ended repayment period. No matter how good your relationship with the borrower is, save yourself future headaches and misunderstandings by agreeing on a loan term from day one.

Amortization Schedule

The amortization, or repayment, schedule is a table that shows the payments to be made over the loan term. The regular payments can include interest and principal components or interest payments only with a balloon payment of principal at the end of the loan term. The amortization schedule also details the frequency of payments. The most common payment schedules are monthly, bi-monthly, quarterly or weekly. As with the loan term, you should agree on an amortization schedule before lending.

Loan Security and/or Special Terms

You probably aren’t considering lending to someone you think won’t pay you back. But unexpected things can happen, and all loan agreements carry a certain amount of inherent risk. Now is the time to consider what should happen if your friend or family member cannot repay the loan. Are you comfortable granting an unsecured loan, or do you want some form of loan security (or collateral)? This is an asset or set of assets that will transfer to you in the event the borrower cannot meet the obligations detailed in the loan. The most common form of loan security is the asset purchased with the loan (e.g. the title to a car, the deed to a home, equipment purchased for a business, etc.).

Once both parties have agreed on all the basic components of the loan, its time to create and sign a formal loan agreement. At LoanBack, your loan document will be automatically generated and ready to download as a PDF file after you have built your loan using our loan wizard. Once your loan has started, you can also use LoanBack to set up regular payment reminders and track payments online.

More Information
Promissory Notes: Personal Loans to Family and Friends – Findlaw.com
Promissory Note – Wikipedia.com