How to set up a loan agreement with friends or family
Whether you are lending or borrowing money, loans between friends and family offer many advantages. However, it is important to protect everyone, which is why you may need to consider entering into a loan agreement.
What is a loan agreement?
Much like the type of agreement you formally enter into with a bank when getting a loan, a loan agreement is a legally binding document that protects both the borrower and the lender. These agreements stipulate and enforce the agreements made by the two parties and describe the terms and conditions surrounding the loan.
Loan agreements can vary widely, but for the basic format you can check out this free pdf loan agreement to help you write your own.
Advantages of loan agreements between friends and family
By borrowing money from a friend or family member, you can avoid taking out a bank loan. There are many benefits that come with it, the main one being either a discount or no interest on the money you pay back. Also, it’s unlikely that someone close to you will ask for your credit score or ask you to provide other documents that a bank might use to deny your loan application.
Since they’re your friends or family, they’ll likely be much more lenient with repayments and probably won’t ask for collateral if you’re unable to meet certain predefined repayment dates. On the other hand, if you are the lender, you can bestow these benefits on a loved one, setting them up for greater financial success.
Why should I set up a loan agreement?
When borrowing or lending money between close friends and family members, it may seem easier to transact without any legal documentation. However, loan agreements ensure that the lender is financially protected, with a legally binding promise in place to guarantee that they will receive repayments on the money they have lent.
Having official documents detailing your loan will also protect you from further taxation or IRS investigation for the money you received. Creating a paper trail for all your financial transactions is extremely important and can save you from facing civil or criminal charges.
What should I include in my loan agreement?
Whether you are setting up a loan agreement between you and a bank or between your family and friends, there are some key elements you need to include. Keep in mind that all of this information should be clear and concise so that anyone reading the agreement can fully understand it without any misinterpretation.
The main sum
In simple terms, it is the amount of money borrowed. It can be paid in installments or in a single payment, but any money agreed to be transferred from one party to the other must be clearly stated.
It should be specified when the money should be repaid and on what date. Often repayments will be in installments, paid monthly, quarterly or annually until the sum is repaid in full or until the lender is satisfied. Rather than fixed amounts, repayments could stipulate that a percentage of the borrower’s income is paid instead.
When family or friends agree to borrow or lend money, they may not charge as much interest as a bank would, if at all. However, if the borrower and lender agree that interest will be paid, it should be specified how much and how this affects the repayment installments. This interest can be calculated.
If specific dates are given on which the borrower must pay a certain amount of money, all the consequences of these late payments must be fully detailed in the loan agreement and agreed to by both parties.
Default of payment
As with late payments, any consequences for the borrower of not repaying the full or specified amount should be included in detail. This may include forfeiture of collateral assets or may result in legal action, depending on the agreement.
To be legally binding, a loan agreement requires the lender and the borrower to sign the contract and will ideally have at least one neutral witness who should also sign the contract, although this last part is not a legal obligation.
What additional clauses should I consider?
People are much more lenient when dealing with family and friends, so you may want to include additional clauses in your loan agreements with them. Some clauses may allow the lender to default without repercussions in certain parameters, such as losing their job or becoming too ill or injured to work.
There are many other clauses that you could implement, either to protect the lender or the borrower, which can further protect the relationship between the two parties.