A loan agreement between friends is a short written contract that names both people, states the amount and date of the loan, sets an interest rate at or above the IRS minimum, lays out a repayment schedule, and defines what happens if payments stop. Done properly, it turns an informal favor into an enforceable debt and keeps the IRS from recharacterizing the money as a taxable gift.
Name the Parties and the Principal
Write out the full legal names of the lender and borrower exactly as they appear on a driver’s license or passport, with current mailing addresses for each. Those addresses are where legal notices go if the matter ever reaches court.
State the principal in both numerals and words (“$10,000 / Ten Thousand Dollars”) and the exact date the money changes hands. This single line is what proves the transaction was a loan rather than a gift, which matters if the IRS questions the arrangement or a dispute lands in front of a judge. Note the method of transfer too (check, wire, electronic payment) so there is no argument later about when the funds actually moved.
Set an Interest Rate the IRS Will Accept
Charging zero interest feels generous, but federal tax law treats a loan priced below the Applicable Federal Rate as if the interest had been charged anyway. The IRS imputes the missing interest as income to the lender and treats the gap as a gift from the lender to the borrower, which can create tax liability for both sides on money nobody actually received or paid.
The AFR changes monthly and varies by loan term. For January 2026, the minimum annual rates were 3.63% for short-term loans (up to three years), 3.81% for mid-term loans (three to nine years), and 4.63% for long-term loans (over nine years).1IRS.gov. Section 1274 Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property Check the current month’s revenue ruling on IRS.gov before finalizing the agreement.
There is one exception worth knowing. Loans of $10,000 or less are generally exempt from the imputed interest rules, provided the borrower doesn’t use the money to buy income-producing investments.2Office of the Law Revision Counsel. 26 USC 7872 Treatment of Loans With Below-Market Interest Rates Above that threshold, charging at least the AFR is the cleanest way to avoid gift tax questions.
Express the rate as an Annual Percentage Rate and state whether interest is simple or compound. Simple interest is easier for both parties to verify.
Stay Below Your State’s Usury Cap
The AFR is a floor; state usury law sets a ceiling. Most states cap personal loan interest somewhere between 6% and 16%, with wide variation by state and loan type. Charging above the cap can void the interest portion of the agreement. Some states go further: a lender who violates the usury limit may forfeit all interest, lose the right to collect even the principal, or face civil liability for double the interest the borrower paid. A handful of states treat the worst violations as criminal. Set a rate at or just above the AFR and well below your state’s cap.
Spell Out the Repayment Schedule
The agreement needs to answer three questions in plain terms: how much is each payment, when is it due, and when is the loan paid off.
The two standard structures are a single lump sum on a fixed date and equal monthly installments. Monthly installments work better for larger loans because they fit normal budgeting cycles and give the lender a regular signal about whether the borrower is keeping up. For each installment, list the exact dollar amount and due date.
State clearly whether the borrower can pay the loan off early without a penalty. For most personal loans between friends, prepayment should be allowed, and saying so in writing prevents an awkward conversation if the borrower comes into money.
Define Default and Its Consequences
Nobody expects a friend to stop paying, but the agreement has to address it. This is the section that does the real work if the relationship sours.
Distinguish a late payment from a default. A common structure is a grace period of five to ten days past the due date before a payment is considered late. Default is more serious: two consecutive missed payments or more than 30 days without paying are standard triggers. Late fees, if used, should be a flat dollar amount or a small percentage, proportional rather than punitive.
Acceleration Clause
An acceleration clause lets the lender demand the full remaining balance immediately on default. Without it, the lender would have to chase each missed payment separately.3Legal Information Institute (LII) / Cornell Law School. Acceleration Clause Tie the clause to the specific default triggers already defined so the borrower knows exactly what conduct can accelerate the loan.
Right to Cure
Give the borrower a written notice period, typically 15 to 30 days, to fix the default before acceleration takes effect. A right-to-cure provision keeps the agreement firm but fair and gives the lender a documented record of acting reasonably before demanding the full balance. Require the default notice to be delivered in writing, by certified mail or email with confirmed receipt, so the start of the clock is clear.
Collateral and the UCC-1 Filing
For larger loans, the lender may want a security interest in specific property the borrower owns, such as a vehicle, equipment, or valuable personal property. If the borrower defaults, that collateral gives the lender a claim ahead of unsecured creditors.
An enforceable security interest requires a written description of the collateral specific enough to identify it. Broad language like “all of the borrower’s property” will not hold up. “2022 Toyota Camry, VIN 4T1B11HK8NU000000” is enforceable; “borrower’s car” is not.4Legal Information Institute (LII) / Cornell Law School. UCC 9-203 Attachment and Enforceability of Security Interest Both parties must sign the security agreement, the lender must give value (the loan counts), and the borrower must have rights in the collateral.
Creating the security interest between the two of you is only step one. To protect that interest against other creditors, file a UCC-1 financing statement with the borrower’s state Secretary of State. The public filing puts other creditors on notice and establishes priority if the borrower takes on additional debt. Fees vary but typically run $20 to $50 for an online submission.5Legal Information Institute (LII) / Cornell Law School. UCC Financing Statement Skip this step and a later-filing creditor can leapfrog you.
Handle the Tax Side
Borrowed money isn’t income, so the borrower owes nothing on the loan proceeds themselves. The lender’s side has more moving parts.
Interest Income
Any interest the lender receives is taxable, reported on Schedule B of Form 1040, whether or not the borrower issues a 1099-INT.6Internal Revenue Service. Topic No. 403 Interest Received If the total interest paid in a calendar year reaches $10 or more, the borrower is technically required to file a Form 1099-INT reporting that amount.7Internal Revenue Service. About Form 1099-INT Interest Income In practice, most friends skip the 1099; the lender still owes the tax.
Below-Market Loans and Gift Tax
Charge less than the AFR and the IRS treats the shortfall between what you charged and what you should have charged as a gift from lender to borrower. That same foregone interest is also imputed as interest income to the lender,2Office of the Law Revision Counsel. 26 USC 7872 Treatment of Loans With Below-Market Interest Rates so the lender can owe tax on money never actually collected.
The annual gift tax exclusion for 2026 is $19,000 per recipient.8Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026 If the imputed gift stays under that threshold, no gift tax return is required. On most reasonably sized personal loans between friends, foregone interest won’t come close to $19,000 in a year. On a very large zero-interest loan it can. Charging the AFR removes the issue entirely.
Forgiven Loans
If the lender later forgives part or all of the balance, the forgiven amount is generally treated as a gift. Forgiveness above $19,000 in a single year triggers a gift tax return (Form 709), though actual gift tax usually isn’t owed unless the lender has exceeded their lifetime exemption.9Office of the Law Revision Counsel. 26 USC 2503 Taxable Gifts The borrower may owe income tax on cancellation-of-debt income if the forgiveness doesn’t qualify as a gift. Put any forgiveness in writing and keep records showing it was intended as a gift.
Sign It Properly
Both parties sign and date the document. A neutral witness or notary makes the agreement much harder to challenge later. A notary verifies each signer’s identity and applies an official seal; fees run roughly $2 to $25 depending on the state. Small expense, significant credibility.
Electronic signatures are valid under federal law. The Electronic Signatures in Global and National Commerce Act provides that a contract cannot be denied enforceability solely because it was signed electronically.10Office of the Law Revision Counsel. 15 USC 7001 General Rule of Validity If you use an e-signature platform, make sure both parties affirmatively consent to the electronic process and that the platform generates a timestamped audit trail.
Keep the Records You’ll Need Later
Each party should keep an original signed copy, physical or digital, with a backup in a separate location. Beyond the agreement itself, maintain a payment log that tracks every payment date, amount, and method. A shared spreadsheet works, or the lender can send a brief written acknowledgment after each payment. These records are evidence in court and documentation for the IRS. Keep everything for at least three years after the loan is fully repaid, matching the standard IRS audit window.
If the Borrower Stops Paying
A well-drafted agreement gives the lender a clear path to recovery. Small claims court handles disputes up to a dollar limit that varies by state, generally $2,500 to $25,000. Many personal loans between friends fit inside those limits, and small claims court is designed to work without an attorney. Bring the signed agreement, the payment log, and any correspondence about the default.
For loans above the small claims threshold, you’ll likely need to file in a higher civil court, which usually means hiring a lawyer. This is where the acceleration clause earns its keep: it gives the court a contractual basis to award the full remaining balance rather than forcing the lender to litigate each missed payment separately. If the loan is secured and the UCC-1 was filed, the lender also has priority access to the pledged asset.5Legal Information Institute (LII) / Cornell Law School. UCC Financing Statement