Lending Money

Thinking about helping out someone in need? Here’s what you need to know about lending money to others—so you can help them succeed without putting yourself at risk.

A Grand Guide

Don’t get in over your head. If you’re going to lend money to anyone, whether it be a friend, colleague, neighbor, stranger, or family member, know what you’re getting yourself into and do it right. When all your bases are covered, lending money to others can change lives for the better!

Enter: Lending Money

Let’s get you ready to be a changemaker without risking your own financial security or relationship. 💸 Here’s what it takes to lend money to friends and family.

What we’ll cover:

The Psychology Behind Lending Money

Everyone struggles with it, you are not alone.

Superhero Pigeon

For most Americans, money is the number one stressor. 😖 In fact, 73% of Americans say finances are their top source of stress. That number is even higher when you narrow it down to Gen Z’ers (82%) and millennials (81%). As a result of this stress, financial hardship is a top reason for people to seek out therapy.

We don’t love seeing others go through these hardships, which is why lending money is a potential solution. But there are fears that accompany lending money, too. Will you get your money back? Will it strain your relationship? Are you stressed at the thought of asking for payments from your loved one?

Fortunately, there are ways to avoid this. Modern social lending platforms like Pigeon 🐣 set you up with a promissory note, send payment reminders on your behalf, and keep track of any desired loan documentation you need. This eases the financial burden for your loved ones without sacrificing your own mental health.

Social lending platforms like Pigeon, have the power to transform the state of lending to others around the world - especially in the US. Of the 41% of Americans who recently lent money to a loved one, about a quarter regretted giving the loan because of one key reason: bad communication. With the right tools, knowledge, and resources overcoming these pains are easy to avoid.

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Examples of What Giving Out Loans to Others Looks Like

Here’s an example of an ideal financial situation between friends:

Jad agrees to lend $15,000 to his close friend Julian. It’s a decent sum of money for Jad, but he feels comfortable lending the money with an official loan agreement in place. Julian will use the money to renovate his new community artist studio in Berkeley, California. 🎨 The friends set up a contract that states the terms of the loan, including a lump sum payment to be repaid over the course of 15 months starting three months after payment. Jad also adds a 3% interest rate to make the loan work for him. Thanks in part to a promissory note with set terms, Julian pays on time every month and the loan goes smoothly.

Jad and Friend

Here’s an example of a not-so-ideal personal loan situation between family members, and how it could have gone better:

Alma lends money to her cousin Alan under a verbal agreement. Alan needs $2,500 to have enough money for a 20% down payment on a new home and avoid private mortgage insurance, so Jenna provides the lump sum and says she’ll need the money back in three months. After two months, Alan asks for more time. ⏰ Alma agrees but doesn’t get a revised time frame for the repayment plan. She has to check in with Alan at least three times before he gives her a time frame. Alan eventually pays Alma back, but it takes 15 months and multiple payments. Alma is frustrated with Alan, but the situation could have been handled better or avoided entirely if she documented the terms of their agreement.

Frustrated Alma

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Why You Should Charge An Interest Rate When Lending Money

Charging even a small amount of interest on a loan helps you avoid tax complications.

Charging even a small amount of interest on a loan helps you avoid tax complications. The Internal Revenue Service (IRS) treats loans and gifts differently for taxes. If you give a gift of more than $15,000 to any person in a single year, it will eat into your finite lifetime gift tax exemption and potentially trigger a 40% gift tax. Oof. 🤯 If you fail to charge an interest rate on a loan, the IRS may view it as a gift, leading to tax consequences for you. 

Even if you don’t charge interest and the IRS does determine the money was a loan, you may still owe taxes on interest you never actually collected. These taxes could be based on the federal minimum interest rate for private loans (more on that below).

The gist: The IRS considers interest that you earn on a personal loan to be taxable income. If you lend a loved one money and charge a small interest rate, you will only be taxed on that small interest rate. The income tax rate is smaller than a gift tax and you can still earn a bit of money for your loan. 💯

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Not Sure How To Calculate Interest?

Math can be a headache, especially number crunching that could put your relationship at stake. Make sure you know the type of interest you would like to charge (compound vs simple), the legal rates you need to charge, and how to calculate the impact on the total value of your loan. Be smart, and use our calculators to help you get through this process.

What interest rate should you charge?

Interest rates on personal loans don’t look like interest rates on credit cards. The IRS updates the Applicable Federal Rate (AFR) monthly. The AFR is the minimum interest rate you should charge for your loan in order to avoid tax consequences.

The AFR is based on the loan’s length (short-term, mid-term, or long-term) and compounding period (annual, twice yearly, quarterly, or monthly). 

For example, in April 2022, the AFR ranges from 1.26% to 3.29% depending on loan term and interest compounding frequency.

There’s also a maximum interest rate you can charge, according to usury laws in your state. For example, the legal interest rate limit in Delaware is 5% above the Federal Reserve rate, while the legal interest rate limit in Hawaii is 10–12%. 

Pro tip: You don’t have to charge interest if your loan is less than $10,000 and the borrower isn’t using the money to buy an income-producing property. ← Not Financial Advice 😎

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6 Elements All Loans Should Include

Aside from these core components, you may also want to include other terms like: the ability for either party to terminate the agreement, and what happens in the event of a default.

Names, Locations, and Signatures of the Borrower and Lender

You’ll want this information in case anything goes wrong.

Due Date and Amount of Money in Payout(s)

Giving your loan a timeline and clear repayment amounts keeps everyone on the same page.

Interest Rate as an Annual Percentage Rate

Defining your interest in APR is standard across all loans. Including an interest rate in your loan helps you avoid gift taxes and can prevent your loan from being illegally usurious.

Repayment Terms (frequency, method, and dates)

Terms in which repayments are returned will keep everyone informed, sustain your relationship, and will soothe any unexpected tensions.

Dispute Resolution

Deciding ahead of time how to resolve a dispute and adding resolution procedures to your loan agreement will prevent any surprises in the future.

Secured vs Unsecured

Tying the value of your loan to another asset or debt is an option to consider when creating a loan. Most loans between people who already have a prior relationship are unsecured, while loans between strangers may be secured with an asset like a car, house, or boat.

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Co-Signing A Loan For a Loved One

Is this alternative to lending money better?

If your loved one is looking for a lower interest rate on a loan, a personal loan is a great option. However, it’s possible that getting a cosigner for a loan from a traditional financial institution such as a bank may provide a favorable rate. This is especially true if the cosigner has a better credit score than the borrower.

Is co-signing a loan for a friend or family member better than lending them the money?

No, and there’s one key reason why. 👇🏽

If you cosign a loan for someone you know, you’re committing to repaying the loan if they fail to do so for whatever reason.

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Should I Take My Borrower to Court?

Lending money to someone using an official loan contract means the borrower is legally obligated to repay the loan. If they fail to repay the loan based on the specified repayment terms, you can take them to court. In this case, the borrower is still on the hook for the loan—not you.

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FAQs About Lending Money to Others

Answers to your most commonly asked questions about lending money.

When should you avoid lending money to someone you know and when should you proceed?

If someone you know wants to borrow money as a loan but won’t agree to your terms or sign a contract, you may want to avoid it. 

There are other scenarios that may keep you from lending, like if you’re Muslim and want to remain Sharia-compliant (in many cases, charging interest is considered making profit off a loan, which is haram). To work around this, you may be able to meet with a tax professional or certified financial planner to calculate how much interest you can charge on the loan without actually profiting.

In most other cases, lending money to loved ones is a safe bet and can help financially propel your friends and family in life.

What is hard money lending?

Hard money lending is a form of lending that does not come from traditional lenders, but rather individuals or private companies that accept property or an asset as collateral.

If a person defaults on a secured loan from a hard money lender, the lender can potentially take over ownership of the asset tied to the respective loan in order to recoup their losses.

Can you lend money to someone starting a business?

Yes, and starting a business is one of the top reasons people lend money to others! If someone you know wants to borrow money for a startup or a small family shop, you can request an official pitch—like any bank or investor would.

While you can invest in the business in exchange for equity, lending money is a good alternative for people who don’t want to be involved in the company.

Does the Truth In Lending Act (TILA) apply to loans for family and friends?

The TILA has protected consumers from predatory lending since 1968. It applies to most closed-end and open-end consumer credit, making sure borrowers are fully aware of all late payment fees, interest rate increases, and additional costs.

Because TILA protects consumers from financial businesses, it does not apply to individuals lending money to other individuals. However, a fully-fledged loan contract (including any signed revisions) will protect lenders and borrowers under U.S. law—so family and friend loans are still safe.

Can lending money cause problems in a relationship?

Only if you do it wrong! Here’s how to avoid causing interpersonal problems: 

Negotiate terms ahead of time
Sign a written agreement
Put protections in place for both parties

How To Avoid Relationship Problems

Should you use a personal loan contract platform when lending money?

Yes!

Using a loan creation tool like Pigeon to build your loan is extremely helpful and smart. Pigeon generates your contract and other loan documents, keeps track of any revisions, and sends payment reminders on your behalf. It makes lending money to friends and family as easy and painless as it can get it.

Build Your Own Contract

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Bottom Line

Lending money can be nerve-wracking, especially when if there's a relationship with a loved one on the line. However, by being smart about it - charging the right interest, preparing for taxes, negotiating repayment, and using personal loan tools at your disposal (like Pigeon 🐦), it can be a win-win for everyone involved.