How to Lend Money to a Friend Legally: Notes, Interest, and Taxes

To lend money to a friend legally, put the loan in writing with a signed promissory note, charge at least the IRS Applicable Federal Rate on any loan over $10,000, keep the rate below your state’s usury cap, send the funds through a traceable payment method, and log every repayment. Those five steps turn a favor into an enforceable debt and keep the IRS from treating your money as a gift.

Why a Written Agreement Comes First

A handshake loan carries two risks at once. If your friend stops paying, you’re left arguing that a verbal deal existed, which is hard to prove and easy to dispute. And if the IRS looks at the transfer, it can reclassify the whole amount as a gift rather than a loan when there’s no promissory note, no repayment schedule, and no evidence that interest was charged. A reclassification eats into your lifetime gift tax exemption and can force you to file a gift tax return.

Courts weighing whether a transfer between individuals is a genuine debt look at whether it was documented in writing, whether interest was charged, whether a repayment schedule existed, whether actual payments were made, whether the borrower could realistically repay, and whether both sides behaved as if this were a real lending arrangement. A signed agreement is what carries you through those factors, and it is the single strongest piece of evidence if you ever need to sue.

Terms to Agree On Before Any Money Moves

Settle every material term with your friend before you draft anything:

Principal amount, written in both words and numbers (for example, “Ten Thousand Dollars ($10,000.00)”).
Interest rate, and how it compounds.
Repayment schedule — monthly, quarterly, or a single lump sum — with specific due dates and amounts.
Late fees, as a flat dollar amount or a percentage, plus any grace period.
Default terms, including how many missed payments trigger default and what happens next. A common consequence is acceleration, meaning the full remaining balance becomes due immediately.

For a larger loan, you can ask your friend to pledge collateral, such as a vehicle. Under the Uniform Commercial Code, a secured party can repossess collateral after default either through the courts or through self-help, provided repossession doesn’t breach the peace.¹ To make that right stick against other creditors, you’d file a UCC-1 financing statement with your state’s secretary of state.

Interest Rates: State Caps and the IRS Floor

Two separate rules bracket what you can charge.

State Usury Caps

Every state sets a maximum interest rate on private loans, and the ceilings vary widely. Some states cap small personal loans well below 20 percent; others allow higher rates or exempt certain loan types. Charging above the cap can void the interest entirely, expose you to penalties, and in some states create criminal liability. If you’re unsure of your state’s limit, check with your state banking regulator before you commit to a rate.

The Applicable Federal Rate

Federal tax law sets a floor. For gift loans over $10,000 between individuals, the IRS expects you to charge at least the Applicable Federal Rate, which it publishes monthly. Charge less, and the IRS treats the shortfall as “forgone interest” and splits it into two imaginary transactions: a gift from you to the borrower, and an interest payment from the borrower back to you. You can end up owing income tax on interest you never received, and the same amount counts as a gift for gift tax purposes.²

The AFR has three tiers based on the loan’s term. As of January 2026, the annual-compounding rates are 3.63 percent for short-term loans (three years or less), 3.81 percent for mid-term loans (over three years but not more than nine), and 4.63 percent for long-term loans (over nine years).³ These change monthly, so pull the current figure before you finalize your rate.⁴

Small-Loan Exceptions

Loans of $10,000 or less between individuals sit outside the below-market loan rules entirely, as long as your friend isn’t using the money to buy income-producing assets like stocks or rental property. Between $10,000 and $100,000, there’s a partial break: the imputed interest you’d owe income tax on is capped at the borrower’s actual net investment income for the year, and if that income is $1,000 or less, it’s treated as zero. Gift tax treatment can still apply. Once the loan crosses $100,000, the full imputed interest rules kick in with no cap.²

What the Promissory Note Should Contain

You don’t need a lawyer to draft the note, but every material term has to be on the page:

Full legal names and addresses of lender and borrower.
Date of the agreement and the date funds will be disbursed.
Principal amount, in words and numbers.
Interest rate and how it compounds.
Repayment schedule with specific dates and amounts.
Late payment terms and any grace period.
Default provisions, including triggers and consequences such as acceleration.
Description of any collateral pledged.
Signature and date lines for both parties.

Templates from reputable legal document services cover these elements. Read each clause and replace the defaults with the terms you actually agreed to.

Signing It So It Holds Up

Both parties sign and date the agreement, and each keeps an original. Without signatures, the document is a draft.

A neutral witness — someone with no financial stake in the loan — adds protection by signing and dating alongside you, and can later testify that the signing was voluntary. A notary public goes a step further, verifying each signer’s identity through government ID and applying an official seal. Notarization isn’t required for a promissory note to be valid, but it makes the document much harder to challenge.

Electronic signatures are generally recognized as legally equivalent to ink signatures under federal law for most contracts. For promissory notes specifically, standard practice still favors wet-ink signatures. If you’re signing remotely, an e-signature beats no signature; on paper is the safer default.

Sending the Money and Tracking Repayment

Transfer the funds in a way that creates a paper trail: a bank transfer, a personal check, or a digital payment service. Cash leaves you with no proof of disbursement if your friend later denies receiving it. The transfer record should match the principal and date in the note.

Once payments start, keep a running log with the date, amount, and remaining balance after each payment, backed by your bank statements. That log does two jobs: it tracks the balance, and it shows the IRS or a court that the arrangement is functioning as a real debt.

If your friend hits a rough patch and you agree to change the schedule, write it down. Draft a short amendment with the new terms, have both sides sign, and attach it to the original. A verbal extension may feel generous, but it weakens the documented structure protecting both of you.

Taxes You’ll Need to Account For

Interest You Collect Is Income

Any interest you receive on the loan is taxable and goes on your federal return. There is no minimum threshold below which interest income is tax-free. If you charged below the AFR on a loan over $10,000, the IRS treats the forgone interest as income to you even though it never hit your account.²

Gift Tax on Forgone Interest

Forgone interest on a below-market loan is also treated as a gift from you to the borrower. If that imputed gift plus any other gifts to the same person during the year exceeds the annual gift tax exclusion of $19,000 for 2026, you’re required to file Form 709.⁵ Filing usually just reduces your lifetime exemption rather than producing an out-of-pocket tax bill, but skipping the filing when it’s required is a compliance problem.

If You Forgive the Balance

The IRS generally treats canceled debt as taxable income to the borrower.⁶ Debt canceled as a gift is an exception: your friend won’t owe income tax if you’re forgiving it as a gift rather than settling for less than owed. On your side, forgiveness counts as making a gift, which brings the annual exclusion and Form 709 rules back in. For anything of real size, talk to a tax professional before you forgive.

When Your Friend Stops Paying

This is where the written agreement earns its keep. The process usually escalates in stages.

Start With a Direct Conversation

Reference the specific terms in the note. A missed payment is often an oversight or a short cash crunch, and a conversation resolves it. If you agree to adjust the schedule, write the change down and both sign it.

Send a Formal Demand Letter

If informal contact fails, send a written demand. Include the loan date, the amount owed, a deadline for payment (typically 30 days), and a clear statement that you’ll pursue legal action if the deadline passes. Attach a copy of the signed agreement, and send the letter by certified mail so you have proof of delivery. A demand letter shows a court you tried to resolve the matter, and it sometimes prompts payment on its own.

File in Small Claims Court

Small claims court is the practical venue for most personal loans. Filing limits vary by state, generally ranging from $2,500 to $25,000, with most falling between $5,000 and $12,500. You file a claim, pay a modest fee, present your evidence at a hearing, and a judge decides. Your promissory note, disbursement record, and payment log are the core evidence. For loans above your state’s small claims limit, you’ll file in a higher civil court, where hiring an attorney becomes more practical.

Watch the Statute of Limitations

Every state sets a deadline for suing on a written contract. For promissory notes, that window ranges from about 3 to 20 years depending on the state, with 6 years being common. The clock generally starts on the date of the last missed payment or the loan’s maturity date. A partial payment or a written acknowledgment of the debt can restart it in some states. Once the deadline passes, a court will almost certainly dismiss your claim even if the debt is real.

What the FDCPA Does and Doesn’t Cover

If you’re collecting on a loan you personally made, the Fair Debt Collection Practices Act doesn’t apply to you. That law covers third-party debt collectors, not original creditors collecting their own debts.⁷ You still can’t harass, threaten, or mislead your friend. State laws on creditor conduct apply, and a judge won’t look kindly on aggressive behavior if the case ends up in court.

1
Legal Information Institute. UCC 9-609 Secured Party’s Right to Take Possession After Default
2
Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
3
Internal Revenue Service. Rev. Rul. 2026-2 – Applicable Federal Rates for January 2026
4
Internal Revenue Service. Applicable Federal Rates (AFRs) Rulings
5
Internal Revenue Service. Estate and Gift Tax
6
Internal Revenue Service. Topic No. 431, Canceled Debt – Is It Taxable or Not?
7
eCFR. 12 CFR Part 1006 – Debt Collection Practices (Regulation F)