Many people have the mistaken believe that a promissory note is sufficient when a debt is owed, particularly if the financial arrangement is between friends or family members. However, it’s important to consider what promissory notes lack. They may be promises to pay a given amount by a given date, but this is far from adequate for laying out the terms of a loan. In any form of lending or borrowing, the parties should go beyond signing a promissory note to creating a formal loan agreement that covers these important basics:
Whether the loan is going to be used to finance the purchase of a car, a new home or just pay off credit card debt, you should know ahead of time exactly what you will do with the money you borrow and exactly how much you need to achieve the purpose.
The loan amount (or principal) should be clearly stated in the loan agreement and should be clearly linked to the loan purpose so the lender is confident that the loan is being used for the stated purpose. The loan amount is also required to set up the amortization or repayment schedule.
Loan Interest Rate
Don’t assume that borrowing from a friend or family member will leave you off the hook when it comes to interest. A reasonable interest rate is an essential part of any loan. Set the rate too low, and the IRS could consider the loan a gift, which has different tax obligations. A rate that’s too high could violate your state’s usury (excessive interest) limits and endanger your ability to repay the loan at all. Depending on the loan purpose and amount, there are different benchmarks you can use to set an appropriate interest rate. For more information check out “How to Determine the Interest Rate on a Personal Loan”
The loan term is the amount of time you have to pay back the loan measured in months or years. As with the interest rate, don’t assume that borrowing from friends and family makes the loan term more flexible. To help ensure successful repayment, and to safeguard your relationship from misunderstandings, agree on the loan term before signing any paperwork.
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. When considering your amortization schedule, be practical and realistic. What can you afford to repay? How often can you afford to make payments? Remember: the faster you pay back the principal of your loan, the less interest the loan will accrue. Depending on the size of your loan, this can mean a great deal of savings in the long run, so you should strive to pay off your loan as quickly as is realistic.
Loan Security and/or Special Terms
The final important component of many loans is the loan security (or collateral). This is the asset or assets that will transfer to the lender in the event you cannot meet the obligations detailed in the loan. The most common form of collateral 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.). Not all friend or family lenders require loan security. A loan without any collateral is known as an ‘unsecured loan’. However, be sure to discuss this with your lender before you finalize your loan so there aren’t any misunderstandings down the road.