What Is a Demand Loan and How Does It Work?

A demand loan is a flexible financial arrangement for short-term needs of individuals and businesses. Unlike traditional loans with fixed repayment schedules, a demand loan allows the lender to request full repayment at any time. Understanding its characteristics and operations is helpful for anyone considering this agreement.

Defining the Demand Loan

A demand loan is a type of financing without a fixed maturity date. The outstanding balance becomes due and payable whenever the lender requests it, or “on demand.” This feature distinguishes it from conventional term loans, which have a set repayment schedule over a specified period.

The flexibility of a demand loan allows borrowers to access funds as needed and repay them at their own pace, subject to the lender’s right to call the loan. This arrangement provides convenience for borrowers with fluctuating cash flows or short-term financing needs. For lenders, it offers liquidity, enabling them to recall funds if their financial circumstances change or they identify other investment opportunities.

Demand loans are sometimes called “call loans” due to the lender’s ability to “call” for repayment. While they lack a fixed repayment schedule, they are used for shorter durations than long-term financing. These loans can be secured by collateral, such as real estate or equipment, providing the lender with assurance of repayment.

Operational Mechanics of Demand Loans

Interest on a demand loan is calculated using a simple interest method, based on the daily outstanding balance. The interest rate is variable, often tied to a benchmark like the prime rate, meaning it can fluctuate over the loan’s duration. Borrowers are required to make regular interest payments, often monthly, to keep the loan in good standing.

The defining aspect of a demand loan is the lender’s right to demand repayment. A lender can request full or partial repayment at any moment, even if the borrower consistently meets all agreed-upon terms. This demand is communicated through a formal notice, and while the exact notice period varies by agreement, it is relatively short. Such a demand letter specifies the amount due, including any accrued interest.

Lenders may call for repayment for various reasons, not always tied to the borrower’s performance. These reasons include economic downturns, strategic shifts within the lender’s portfolio, or a loss of confidence in market conditions or the borrower’s financial stability. From the borrower’s perspective, this means maintaining sufficient liquidity to respond to a demand, as the loan can be called unexpectedly. Borrowers benefit from making partial or full principal payments at any time without prepayment penalties, which reduces total interest paid.

Common Applications and Parties Involved

Demand loans are used in situations requiring flexible, short-term financing. Businesses use them as working capital loans to manage daily operational expenses, such as purchasing inventory, paying employee salaries, or covering rent. They are also useful for short-term business financing needs, including bridge financing, which provides temporary funds until a more permanent solution is secured. These loans offer a quick way for businesses to address immediate cash flow requirements or seize time-sensitive opportunities.

Beyond business operations, demand loans are common in transactions between related parties. This includes loans between family members, allowing for financial assistance with flexible repayment terms. Similarly, intercompany loans within a corporate structure are often demand loans, facilitating cash transfers between parent and subsidiary entities or among affiliated businesses.

Institutional lenders, such as banks and other financial entities, provide these loans to businesses and individuals, requiring a good credit history and sometimes collateral. Brokerage firms use demand loans from banks to finance their clients’ margin accounts, providing immediate access to funds for securities purchases. Individuals, small and medium-sized enterprises (SMEs), startups, and investors looking for short-term capital are common borrowers.

Interest Imputation Rules for Below-Market Loans

A financial aspect of demand loans, particularly those with little or no interest, involves “imputed interest” rules. The Internal Revenue Service (IRS) addresses these arrangements under Internal Revenue Code Section 7872. These rules prevent taxpayers from using below-market interest rate loans to disguise taxable events, such as gifts, compensation, or dividends, thereby avoiding federal tax liabilities.

Under Internal Revenue Code Section 7872, if a demand loan is made at an interest rate below the Applicable Federal Rate (AFR), the law treats interest as if paid, even if no cash changes hands. The AFR is a minimum interest rate published monthly by the IRS, reflecting market conditions. For demand loans, the relevant AFR is the Federal short-term rate. The “forgone interest”—the difference between interest at the AFR and any interest paid—is deemed transferred from lender to borrower, then retransferred back to the lender as interest. This hypothetical transfer and retransfer occur on the last day of the calendar year for income tax purposes.

The lender is required to report this forgone interest as taxable income. While the borrower is deemed to have paid this interest, their ability to deduct it depends on whether the interest would otherwise be deductible under tax rules, such as for investment or business purposes. Exceptions exist; for instance, gift loans directly between individuals totaling $10,000 or less are exempt, provided the loan is not used to purchase income-producing assets. For gift loans up to $100,000, the imputed interest is limited to the borrower’s net investment income for the year, with no imputed interest if that income is $1,000 or less. To simplify calculations for demand loans outstanding for an entire calendar year, the IRS allows the use of a “blended annual rate,” which it publishes annually.