When considering how to loan money to family legally, the first thing you need to keep in mind is that, although your family members genuinely need the loan and believe you can help them, from a legal standpoint, lending them money is no different from lending money to anyone else.
However, what makes situations tricky is the potential for awkward or even strained relationships if the borrower fails to follow the agreed repayment terms, which is a situation you want to avoid.
To help you navigate this process smoothly, we’ve put together key tips on how to lend money to family the right way and what mistakes to avoid to protect both your finances and your relationship. Let’s dive in!
4 Key Considerations Before Lending Money to Family
Before lending money to family members, you should consider all aspects of such a loan and the potential effects it may have. Here are four key considerations to keep in mind:
#1. Setting Clear Terms
Before drafting a legal loan agreement for a family, you need to negotiate a contract and set all the terms of the family loan with the borrower. This primarily includes the loan amount, the repayment deadline, deciding whether they will make monthly payments or repay the full amount at once, and what happens if they fail to repay the loan on time.
You can also choose to include a promissory note with the loan agreement. A promissory note for personal loans is a written promise from the borrower to repay the loan as agreed and outlines all the key terms outlined in the loan agreement, including any collateral requirements.
#2. Determining Interest
Determining interest can be tricky. If a family member asks for a loan, they may not expect to pay interest, which is understandable for smaller amounts. However, for larger sums or long-term loans, charging interest is reasonable.
If you decide to determine interest, be aware that it must comply with state usury laws, which set limits on interest rates. Exceeding these limits could result in penalties or legal consequences, so always check your state’s regulations to ensure compliance and avoid unnecessary risks.
#3. Understanding Tax Implications
It’s important to understand the tax implications of lending money to a family. The IRS sets a minimum interest rate for private loans, known as the Applicable Federal Rate. If you charge less than this rate, the IRS may treat the loan as a gift, which could have tax implications.
For loans over $10,000, any interest earned is considered taxable income. Even if you opt for an interest-free loan to a family member, you might still need to report the loan as a gift if it isn’t repaid. In 2025, you can gift up to $19,000 without triggering the gift tax.
#4. Assessing the Ability to Pay Back
Before finalizing the loan, objectively evaluate your family member’s financial situation to determine their ability to repay. Consider their income, existing debts, and overall financial stability.
Considering these factors will help you make the final decision on whether it’s wise to proceed with giving them a loan or not.
How to Loan Money to Family Legally in 4 Steps
When loaning money to a family, it’s important to handle the process legally to avoid potential conflicts or disputes. Here’s a simple guide on how to loan money to family legally in a few steps:
#1. Draft a Loan Agreement
After negotiating and setting clear terms, it is time to draft a loan agreement. This doesn’t have to be complicated, but it’s crucial to have everything in writing to avoid misunderstandings later on. So, the agreement should outline the following elements:
What to Include in the Loan Agreement
Personal information of the parties
The exact amount being loaned
Repayment terms (repayment schedule and amount due for each repayment)
Interest rate (if applicable)
Late payment penalties (if applicable)
Security instruments, such as collateral (if applicable)
Consequences of non-payment
Signatures and date
#2. Choose the Right Type of Loan
Next, decide which type of loan you want to use—a promissory note or a formal loan agreement. A promissory note for a personal loan is a simple written promise from the borrower to repay the loan as agreed and can be used for smaller loans. This option is less formal but still provides a legally binding document.
On the other hand, a formal loan agreement is a more detailed and structured agreement. This might be a better option for larger loans or when you want to outline specific conditions.
In any case, you’ll have written evidence about the loan, so you don’t have to worry if any disputes arise.
#3. Sign and Notarize the Agreement
Once you’ve drafted the loan agreement or promissory note, both parties should sign it. While it’s not always necessary to have the document notarized, doing so adds an extra layer of legal protection so it can be easily enforced in court if necessary.
Notarizing these legal documents means that a third party (notary public) has witnessed the signing, making it harder for either party to later dispute the terms. When you sign the agreement, ensure that both you and the borrower have copies for your records.
#4. Set Up a Payment Schedule
Lastly, one of the most important aspects of the loan is ensuring there’s a payment schedule in place. This schedule should clearly outline when payments are due, how much the borrower will pay, and what happens if payments are missed.
Once you’ve agreed on the schedule, both parties should stick to it, otherwise, it could lead to misunderstanding and potentially result in legal consequences.
What Happens if They Cannot Repay the Loan?
“What happens if the borrower cannot repay the loan?” is a question that inevitably arises in loan arrangements. It carries even more weight when lending money to family members.
If a family member defaults on the loan, the first step should always be to assess the situation. Try to find out if there are any specific reasons why they haven't honored the family loan repayment terms—due to personal issues, job loss, illness, or something else. Discuss the reasons behind the non-repayment and determine if they have a repayment plan.
Once you've assessed the circumstances behind the non-repayment, discussing and renegotiating the loan terms may be helpful. Renegotiating can be an effective way to avoid legal action, so consider extending the repayment period to make the loan more manageable, especially if the borrower is facing financial difficulties.
Changing a contract to reflect these new terms, such as reducing the interest rate or adjusting the monthly payments, can make the loan more affordable. If the borrower cannot pay in cash, consider alternative forms of repayment, such as asking for assistance with tasks or services in exchange for the debt, as this can help ease the burden while maintaining the relationship.
Like any other loan agreement, a loan contract for relatives can be enforced in court. Therefore, if negotiations fail and the loan is not repaid, you can pursue legal action by filing a civil lawsuit to demand repayment. However, this step will undoubtedly strain your family relationship, so it should be a last resort.
Before pursuing legal action or filing a claim in small claims court, consider sending a formal demand letter notifying the relative about the amount owed and making it a final call for repayment before any further action is taken.
4 Crucial Mistakes to Avoid When Lending Money to Family
Lending money to family members is a delicate matter. Not only do you risk losing the money, but you could also jeopardize the relationship. If not approached carefully, the consequences can be significant. So, let's explore four crucial mistakes to avoid when lending money to relatives:
#1. Don’t Lend More Than You Can Afford
One of the most important rules when lending money to anyone, especially family, is never to lend more than you can afford to lose. By following this rule, you protect yourself from financial strain.
So, avoid putting yourself in a situation where you have to borrow money from others to cover your expenses. Be honest with yourself about your financial situation, and assess whether you're able to lend the money without compromising your financial well-being.
#2. Don’t Lend to Someone You Don’t Trust
Family members are often people you know well—people you've known since childhood and understand their character, which means you likely know how they handle money and responsibility. Use this knowledge when considering whether to give them a loan.
If you doubt their ability or willingness to repay the loan, it's best not to lend the money, as trust is key in these situations.
#3. Don't Skip Clear Terms and Documentation
Even if the borrower is a family member, it's essential not to take the loan lightly, especially if it's a large sum. Discuss the loan's purpose, terms, repayment plans, and other relevant details.
Once you've agreed on the terms, make sure everything is documented in writing. Having a clear agreement, including details about repayment and security instruments, will protect both parties and help maintain transparency.
#4. Don't Let Your Emotions Cloud Your Judgment
Lending money to family can often bring out strong emotions. While your instinct might be to help a loved one, it's important not to let emotions drive your decision-making. Therefore, think about the situation logically. Can the borrower realistically repay the loan? What are the potential consequences if they can't repay it? Will it strain your relationship?
By balancing empathy with caution, you can make a thoughtful decision that won't lead to future complications.
Why a Loan Agreement Alone Isn’t Enough: The Added Security of a Promissory Note
A loan agreement is essential, but adding a promissory note provides extra security and legal protection. With a Contracts.net promissory note builder, you can create a legally binding document that clearly outlines repayment terms, helping you prevent future disputes.
Final Thoughts
Lending money is always a difficult decision and should be carefully considered. When it's a family member asking for help, the first thing we often wonder is how to loan money to family legally.
However, it is essential to consider not just the legal aspects but also the trust you have in the person requesting the loan. By clearly outlining the loan terms in writing, setting a repayment schedule, and documenting everything, you can avoid misunderstandings or disputes.
Taking these steps ensures the loan is secure and you've helped your loved one without facing legal issues or concerns about repayment.
How to Loan Money to Family Legally FAQ
Yes, lending money to family is legal. However, it’s important to have a clear agreement in place to avoid misunderstandings and ensure both parties understand the terms.
Yes, you can change interest when lending money to a friend, but the rate must comply with state usury laws. Charging an interest rate higher than the allowed limit could lead to legal consequences or penalties.
Generally, personal loans to family members aren’t tax-deductible. However, if the loan turns into a gift it may have tax implications and could be subject to gift tax rules.
While it’s not legally required, having a contract when lending money to family is highly recommended. You may also consider including a promissory note for a family loan, which serves as a written promise to repay the loan according to the agreed terms.
