A loan agreement between family members should be a written promissory note that spells out the amount lent, the interest rate, when and how the borrower will repay, and what happens if payments stop. Get those terms on paper before any money moves. That single step keeps the arrangement enforceable, keeps the IRS from recharacterizing the money as a gift, and gives both sides something concrete to point to if memories drift.
Terms the Document Must Contain
Identify both people by full legal name and current home address. Vague identification is the kind of gap that becomes expensive later. State the principal amount as an exact dollar figure, and if the money will go out in installments, list each amount and its expected date.
Record the disbursement date, meaning the day the funds actually transfer. Interest accrual and repayment deadlines run from that date. Then define the repayment structure: monthly installments, quarterly payments, or a single lump sum at maturity. For installment loans, include the payment amount and the day of the month it’s due. State the payment method too. Bank transfers and checks leave a trail; cash doesn’t, and cash payments on a family loan are the ones people argue about.
Set a maturity date. Short-term family loans often run three years or less; longer arrangements can stretch to ten or fifteen. Promissory note templates from legal form sites handle most of this formatting, but read every field. A missing date or ambiguous payment amount is exactly the sort of thing that tears families apart when money gets tight.
How Payments Get Applied
Say in the document how each payment is allocated. Commercial lenders apply payments first to accrued interest, then to principal, and last to any late fees. Without that language, a $500 payment can mean two different things to two people. Put the order in writing and the argument never starts.
Attach an Amortization Schedule
For any installment loan with interest, attach an amortization schedule. It breaks each payment into interest and principal and shows the running balance. Free online calculators generate one in seconds. The borrower can see the debt shrinking; the lender has a ready record for reporting interest at tax time.
Setting the Interest Rate
Family loans sit between two boundaries. The IRS sets a floor, and state usury law sets a ceiling.
The Applicable Federal Rate
Under federal tax law, a loan between family members that charges less than a government-set minimum is a “below-market loan.” The IRS then imputes interest on the shortfall, meaning the lender owes tax on income they never actually received, and the forgone interest is treated as a gift from lender to borrower, which can trigger gift tax reporting.
That minimum is the Applicable Federal Rate, and the IRS publishes new AFRs each month. The rate depends on the loan’s term. As of February 2026, the short-term rate (3 years or less) is 3.50%, the mid-term rate (over 3 years and up to 9 years) is 3.79%, and the long-term rate (over 9 years) is 4.61%.1Internal Revenue Service. Revenue Ruling 2026-3, Applicable Federal Rates Use the AFR from the month you fund the loan and record that month in the agreement. That locks in a safe harbor for the life of the loan.
Two Exceptions for Smaller Loans
The tax code carves out relief for smaller family loans. If the total outstanding balance between the two of you stays below $10,000, the imputed interest rules don’t apply. That exception disappears if the borrower uses the money to buy income-producing assets like stocks or a rental property.2Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
For loans where the total balance stays at or below $100,000, the imputed interest the lender must report is capped at the borrower’s net investment income for the year. If that net investment income is $1,000 or less, it’s treated as zero, which effectively zeroes out imputed interest. The cap goes away once total loans between you exceed $100,000, and it doesn’t apply if tax avoidance is one of the principal purposes of the arrangement.2Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
State Usury Limits
State usury laws cap the interest a private lender can charge. Most state maximums for private loans fall between 6% and 25%, though the specifics vary. Charging above your state’s cap can void the interest entirely or expose the lender to penalties. A family loan set at the AFR will almost never bump into a usury ceiling, but if you’re pricing in real risk with a higher rate, check the state limit before signing.
What Happens If Payments Stop
The default sections are the ones you hope you never need. Handshake loans fall apart here, because without written terms the lender has no defined recourse and the borrower has no defined obligation once things go wrong.
Grace Period and Late Fee
Define when a payment is late. A grace period of ten to fifteen days after the due date is common and absorbs normal processing delays. After the grace period, a late fee gives the borrower a reason to stay current. A flat dollar amount works; so does a percentage of the overdue payment, with 5% being typical. Put a specific number in the document so nobody has to guess later.
Acceleration Clause
An acceleration clause lets the lender demand the entire remaining balance at once when the borrower breaches a defined term, usually after a set number of missed payments. Without it, a lender who sues can typically only recover the individual payments that were missed, not the full outstanding debt. On a $50,000 loan where two payments have been skipped, that difference is significant. Spell out the triggering events: how many missed payments, which specific breaches, and how much notice the borrower gets before acceleration kicks in.
Collateral
On a larger loan, the lender may want to secure the debt against a specific asset such as a vehicle or piece of equipment. The agreement should identify the collateral in detail and include language granting the lender a security interest. To protect priority against other creditors, the lender can file a UCC-1 financing statement with the state’s Secretary of State. For consumer goods bought with the loan proceeds, the security interest is automatically perfected without a filing. Securing a family loan feels awkward. On a significant amount, it’s the most reliable protection the lender has.
Signing, Witnesses, and Notarization
Both parties sign and date the document. Witnesses are not legally required. A signed promissory note is an enforceable contract on its own. Adding one or two witnesses does help if the borrower later claims they never signed; a witness who watched it happen resolves that question fast.
Notarization goes further. A notary verifies each signer’s identity through government-issued ID and applies an official seal. A notarized document is substantially harder to challenge if the loan is ever contested. Statutory notary fees are generally capped at $15 or less per act, though the cap varies by state.
Reporting the Interest as Income
Interest earned on a family loan is taxable. The IRS doesn’t care that the borrower is your sibling or your child. Report total interest income on Line 2b of Form 1040. If you receive more than $1,500 in taxable interest across all sources during the year, complete Schedule B as well.3Internal Revenue Service. Instructions for Form 1040
You probably won’t receive a 1099-INT from your family borrower. That form is generally required only from payers who make interest payments in the course of a trade or business, and a relative repaying a personal loan doesn’t meet that threshold. The absence of a 1099 doesn’t reduce your reporting duty. Track the interest yourself and report it.
If you charged less than the AFR, the imputed interest goes on Line 2b and Schedule B the same way, even though you never received the money. That same imputed amount counts as a gift from you to the borrower and can require filing Form 709 if it exceeds the annual gift tax exclusion.2Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
If You Later Decide to Forgive the Loan
Some family lenders eventually forgive part or all of the balance. That decision has tax consequences on both sides.
For the lender, forgiveness is a gift equal to the forgiven amount. The 2026 annual gift tax exclusion is $19,000 per recipient.4Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026 Forgive more than $19,000 to one person in a single calendar year and you must file Form 709.5Internal Revenue Service. Instructions for Form 709 Filing the form doesn’t necessarily mean you owe tax. Any amount above $19,000 counts against your lifetime gift and estate tax exemption, which sits at $15,000,000 for 2026.6Internal Revenue Service. Whats New – Estate and Gift Tax Most families never approach that ceiling, but the reporting requirement still applies. To forgive a larger loan gradually, forgive up to $19,000 each year and stay within the annual exclusion.
For the borrower, canceled debt is ordinarily taxable income. A specific exception exists for debts canceled as gifts, and a forgiven family loan is almost always intended as a gift, so the borrower generally does not report the forgiven amount as income.7Internal Revenue Service. Topic No. 431, Canceled Debt – Is It Taxable or Not? The tax burden stays on the lender through the gift system rather than hitting the borrower as income.
What Happens If Someone Dies
Death does not cancel the loan, and this is one of the stronger reasons to put the agreement in writing.
If the lender dies, the outstanding balance becomes an asset of their estate. The executor collects remaining payments from the borrower. A written agreement with a clean payment history makes that straightforward. Without one, the executor may not even know the loan exists.
If the borrower dies, the lender becomes a creditor of the borrower’s estate. The executor inventories the estate’s debts and pays valid claims. A written promissory note with documented payments gives the lender a clear, enforceable claim; an oral agreement is much harder to validate.
Consider addressing death directly in the document. Options include requiring the borrower to carry life insurance sufficient to cover the balance, or stating whether the debt transfers to the borrower’s heirs or is forgiven at death. Without that language, your state’s default probate rules control the outcome.
How Long the Lender Has to Sue
Every state limits how long a lender can wait before filing a collection lawsuit on a written promissory note. Deadlines run from 3 to 20 years depending on the state, with 6 years a common period. The clock typically starts from the date of the last payment or the date the borrower first defaulted.
Two details matter. In some states, a partial payment by the borrower restarts the clock entirely, giving the lender a fresh enforcement window. And if your agreement includes a choice-of-venue clause specifying which state’s law governs, that state’s limitations period applies regardless of where either party lives now.
A lender who lets the deadline pass doesn’t lose the moral claim, but the legal one is gone. On a significant loan, write the enforcement deadline somewhere you’ll see it. Waiting too long to act on a defaulted family loan is one of the most preventable mistakes in private lending.