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How to Write a Promissory Note for a Friendly Loan

Promissory note for a friendly loan

No one feels good about asking a friend or family member for a loan. Whether due to poor planning, bad luck or some combination of the two, finding yourself in financial trouble feels bad enough. Having to reveal your problems to a loved one, ask that they reach into their own wallets and then trust you do pay it back?  Well, that’s just not going to be a great day.

That’s why when a loved one approaches you for a loan it can feel like the kindest thing to do is get the exchange over with as fast as possible: Hand over the money, mumble something about paying it back and wait it out.

The problem is, even with the best intentions, your generous gesture can do more damage to your relationship than good. What if they can’t pay you back on time—or at all? What if you suddenly need the money and thought you’d have it back by then? Or what if you both innocently came away from that brief conversation with different understandings of the terms and now must revisit the agreement with an even more difficult conversation?

Awkward and daunting as if may feel, if you are willing to lend money to a loved one (and no one says you must, by the way), writing down your agreement in clear terms can be one of the most caring things you can do. In this sense, more formal agreements—sometimes called “promissory notes”—are a means of protecting your relationship.

What is a promissory note?

The basic element of a promissory note is a written promise that the borrower will pay the lender a specific sum of money in a specified amount of time.

What’s in a promissory note?

Below are the essential details you should include.

  • Names and contact information
    This includes legal names, addresses, email addresses and phone numbers of all interested parties.
  • The amount of money the person will pay back

Some states may also require that you indicate the purpose of the loan (i.e. what it will be used for).

  • Interest rate you plan to charge
    Beyond helping a loved one through tough financial times (and helping them avoid the financial consequences of predatory lenders and Payday Loans), you stand to make a few bucks if you charge interest. This can still be a good deal for the borrower. After all, they will probably dodge higher interest rates than a bank would charge, and your loan may not impact their credit score. If this is of interest (pun intended), you’ll need to decide if you want to charge compound or simple interest. You may also wish to include an amortization table showing the amount of money borrowed (the principal) plus the interest that will be applied over time. Note that some states have interest rate laws that limit how much you can charge for interest. Also beware you may have to report any interest collected on your taxes.
  • The terms of repayment
    Re-payment can be made in monthly installments (with or without any interest added on) or in one lump sum. Also—unfortunately—it’s important to include some serious language about what happens if one of you dies before the loan is repaid. Will the loan be forgiven? Will payments be deducted from their inheritance? Will they owe your estate?
  • A description of collateral
    Collateral is an asset a borrower offers to a lender to secure a loan. In other words, the borrower is saying if they don’t pay back the loan, the lender has rights to that asset. Generally the collateral should be equal to or greater than the amount you are lending. Real estate and recreational vehicles are common examples. The day the loan is paid off is the day the lender forgoes their rights to the collateral.
  • The consequences for failing to meet the terms
    Will you charge late fees for missed payments? If the borrower defaults entirely on the loan, will you enter small claims court? Get a lawyer involved? Or will the borrower be required to forfeit the items secured as collateral?
  • The date and your signatures!

Other details to consider:

Some sources suggest additional elements. You may want to have the document notarized, for example, so no one can later claim the signature isn’t theirs. You may need to include the fact that the lender has the right to transfer the note (the loan) to another party and/or that the borrower has the right to cancel the loan within a certain amount of time of signing the promissory note.

Searching online for “free promissory notes” will pull up forms from a variety of sources that can guide you through the process.

Using a promissory note template helps because you default to existing protocols. And if you think a promissory note is too formal, there are other ways to clarify the details of your agreement. Get the conversation in writing in an email that can be retrieved when needed. The important part is that you set expectations and both agree to them.

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Setting up guidelines and expectations ahead of time helps you avoid arguments and misunderstandings that are commonplace when lending money to a loved one. A written promissory note protects your relationship by helping you avoid awkward—or potentially relationship-ending—conversations later. But no matter how formal the agreement and how well prepared you are, in the end, the best rule when it comes to lending money is: don’t lend it if you can’t afford to lose it.