What Is a Friendly Loan and How Does It Work?
Discover how friendly loans work, including key considerations like repayment terms, tax implications, and what happens if the borrower defaults.
Borrowing money from friends or family is a common alternative to traditional loans. These arrangements, often called friendly loans, rely on personal trust rather than formal financial agreements. While they offer flexibility, they also pose risks. To protect relationships and avoid misunderstandings, both parties should establish clear terms before lending or borrowing money.
Interest and Repayment Terms
Clear expectations for interest rates and repayment schedules help prevent disputes. Some lenders may offer an interest-free loan, but charging interest can account for inflation and opportunity cost. If interest is applied, it should be reasonable and comply with state usury laws.
Repayment terms should specify the loan duration, payment frequency, and acceptable payment methods. A structured plan, such as monthly installments, ensures consistency and reduces the risk of non-payment. If flexibility is needed, both parties should agree on conditions for early repayment or extensions.
A written loan contract is highly recommended. This document should include the loan amount, interest rate (if applicable), repayment schedule, and any penalties for late payments. A signed agreement provides legal protection and reinforces the seriousness of the arrangement.
Collateral Requirements
Unlike bank loans, friendly loans typically do not require collateral, making them more accessible but riskier for the lender. Some lenders may rely solely on trust, while others may prefer additional safeguards.
A promissory note can add security by specifying collateral, such as a vehicle, jewelry, or business shares. If the borrower defaults, the lender has the legal right to claim the asset. However, enforcing collateral agreements can be complicated without proper documentation.
To avoid disputes, any collateral arrangement should be outlined in writing, specifying the asset’s value, conditions for claiming it, and the process for transferring ownership if the borrower fails to repay. For example, if the collateral is a vehicle, the lender may require a lien on the title to prevent its sale before the debt is settled.
Tax Ramifications
The IRS considers certain friendly loans taxable transactions. If a loan exceeds $10,000 and lacks a reasonable interest rate, the IRS may apply “imputed interest” rules under Section 7872 of the Internal Revenue Code, requiring the lender to report interest income even if none was charged. The minimum interest rate should be the Applicable Federal Rate (AFR), updated monthly by the IRS.
For loans above $17,000 in 2024, failing to charge interest at or above the AFR could result in the IRS treating the unpaid interest as a gift. If the total amount given exceeds the annual gift tax exclusion ($18,000 in 2024), the lender may need to file a gift tax return (Form 709). While no immediate tax is usually due unless lifetime gifts exceed $13.61 million, tracking these amounts is essential to avoid unintended tax consequences.
Borrowers do not owe taxes on loaned money since it is not considered income. However, if the lender forgives the debt, the IRS may classify the forgiven amount as taxable income under “cancellation of debt” rules. Some exceptions apply, such as insolvency or bankruptcy, but otherwise, borrowers may need to report the forgiven amount on their tax return using Form 1099-C if it exceeds $600.
Handling Defaults
When a borrower fails to repay, emotions can run high. Addressing the situation promptly can help prevent strained relationships and financial losses. Open communication is key—understanding why payments have stopped can determine whether the issue is temporary or a deeper financial problem. If the borrower is experiencing short-term hardship, restructuring the loan by extending the repayment period or adjusting installment amounts may help.
If discussions fail, documenting all interactions regarding the loan is useful. Keeping records of payment history, missed deadlines, and any revised terms ensures the lender has evidence if further action is needed. In some cases, mediation through a neutral third party can help facilitate an agreement without escalating the conflict. This approach can be effective when both parties want to preserve their relationship but need guidance in reaching a fair settlement.