Whenever you make a personal loan to someone, such as a friend or family member, it is important to write down the terms of your agreement -- for instance, the amount of money that is being lent and when it will be paid back. A promissory note, or loan agreement, signed by both parties can help to prevent any misunderstandings regarding the loan, which may in turn assist in keeping the relationship intact.
Agree to the Terms
Write the loan agreement together, so that you and the recipient of the loan each have a say in formulating the terms. A mutual agreement also helps to make sure neither party feels taken advantage of. For example, if you propose an aggressive payback plan and hand the borrower a document with that schedule for him to sign, your friend may feel he is being set up for failure. Likewise, if your friend wants to take an extraordinary amount of time to return the funds, you may feel he is not taking his repayment obligation seriously enough.
Collateral and Interest
Decide if collateral or interest will be part of the loan agreement. If something of value will be held as collateral until the money is paid back, choose an item that is equal in value to the amount of the loan. Common forms of collateral are electronic equipment, a car title or jewelry, depending on the amount of the loan. If the loan will include interest, decide on the percentage and split the amount evenly among the payments if a payment plan is to be used.
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Bank deposits over $10,000 are automatically reported to the IRS; large loans can look suspicious during an audit if not properly documented. Hence, the promissory note serves as the legal record of the transaction between you and a friend or family member. In the same vein, the IRS may impute interest, which means you will have to report the would-be interest on your tax return as income, whether interest was charged or not. Additionally, the interest rate on the loan should reflect the current market rate; setting the rate too low can be as bad as not charging interest at all in the eyes of the IRS.
Notarize the Loan
Having your promissory note notarized is not an assurance that the loan agreement will be followed as written by both parties. A notary just acknowledges that the signatures on the agreement are legitimate. However, if the loan agreement is notarized, the borrower will have a hard time backing out of the promissory note by saying that he never signed the agreement.