The short version
- A promissory note is a one-sided promise to repay and suits a simple lump sum. A loan agreement is a two-sided contract and is the right instrument once instalments, interest, collateral or default terms are involved.
- The IRS starts from the assumption that money moving between family members is a gift. Contemporaneous documentation is what rebuts that.
- Gift loans between individuals of $10,000 or less are generally outside the below-market loan rules, unless the money buys income-producing assets.
- Above that, charge at least the applicable federal rate for the loan's term, or the forgone interest is imputed to you and treated as a gift to the borrower.
Why undocumented family loans go wrong
Two independent failures, and they compound. The first is evidential: without a document there is no record of the amount, the repayment schedule, whether interest was intended, or what happens if payments stop. Years later, one person sincerely remembers a loan and the other sincerely remembers help. Both are being honest. Neither can prove anything.
The second is tax. Tax authorities generally treat a transfer of money between family members as a gift unless there is evidence it was a loan. That characterisation has consequences — for gift tax reporting, for your lifetime exemption, and for whether you can ever claim a bad-debt deduction if it is not repaid. The document is what establishes that a loan was intended, and it has to exist at the time, not be reconstructed afterwards.
Promissory note or loan agreement?
Both are enforceable. They differ in structure and in how much they can carry.
Which instrument fits the arrangement
Promissory note
- A one-sided written promise to pay
- Signed by the borrower only
- Right for a single lump sum on a stated date
- Short — often one page
Loan agreement
- A two-sided contract with obligations on both parties
- Signed by both
- Right for instalments, interest, collateral or conditions
- Sets out default, acceleration and remedies in full
Anything with a schedule, security, or a consequence for missing a payment belongs in a loan agreement. A note that tries to carry all that is a loan agreement wearing the wrong name.
A useful test: if you can state the whole arrangement in one sentence — "I will repay £8,000 on 1 June 2027" — a promissory note is enough. If it takes a paragraph, use a loan agreement.
What has to be in it
The terms that prevent the argument
- Full legal names and addresses of both parties, and the date.
- The exact principal, in figures and words.
- The interest rate, or an express statement that the loan is interest-free — silence is what creates the tax problem.
- The repayment schedule: amounts, dates and where the money goes.
- How payments are applied — to interest first, or principal first.
- Whether early repayment is allowed, and without penalty.
- What counts as default, and how much notice is given before it bites.
- Any security, and what happens to it — a car, a share of a property.
- What happens if the lender dies before repayment. Without this, the debt becomes an asset of the estate and the executor may have to pursue a sibling.
- Signatures from both parties, dated, with a witness where your jurisdiction expects one.
What the money becomes, depending on two lines in the paperwork
Is there a signed document?
What happens on the lender's death
The document is silent
Forgiven, in the note and the will
Nothing written down
Treated as a gift
No record of amount, schedule or intention. Gift-tax reporting follows, and no bad-debt deduction is ever available.
Still a gift
Forgiveness written into a will does not retrospectively make an undocumented transfer a loan.
A dated note or agreement
A debt the executor must collect
The loan becomes an asset of the estate, and the executor has a duty to pursue it — which is usually a sibling.
What most families intend
A loan while the lender is alive, extinguished on death, with both documents saying the same thing.
Interest, and the rule that surprises people
US tax law does not let you make an interest-free loan of any size and ignore it. Under the below-market loan rules, if you charge less than the applicable federal rate — a rate the IRS publishes monthly, in short, mid and long-term versions — the interest you did not charge is imputed to you as income, and you are treated as having gifted the same amount to the borrower.
Two thresholds keep most family lending simple.
| Loan size | Position | What to do |
|---|---|---|
| $10,000 or less | Generally outside the below-market rules for gift loans between individuals | Document it anyway; interest is optional. The exception does not apply if the money is used to buy income-producing assets |
| Above $10,000 | Charge at least the applicable federal rate for the term, or forgone interest is imputed | Pick the AFR for the month you sign and the term of the loan, and state it in the document |
| Up to $100,000 | A limitation caps the imputed interest by reference to the borrower's net investment income | Relevant to larger family loans; this is the point to involve an accountant |
Outside the US the machinery differs and the principle survives: an undocumented transfer to a family member will usually be treated as a gift by default, and gifts can have tax and inheritance consequences that a loan does not. Confirm the local position before assuming your arrangement is invisible.
Loan agreement template
Full text free to read and copy — principal, interest, schedule, prepayment, default, acceleration and security, with the clauses that matter for a private loan already in place.
If you are the one borrowing
The document protects you too, and in ways that are easy to underestimate.
- It caps the obligation. A written amount and schedule cannot expand later into a larger figure someone remembers differently.
- It ends the standing question. With a schedule in place, nobody has to ask how it is going at Christmas.
- It proves the money was not income. Useful if you are asked to explain a deposit — by a mortgage lender, a benefits assessor, or a tax authority.
- It records what happens if you cannot pay. Agreeing now that a missed payment triggers a conversation rather than a demand is much easier than negotiating it in the middle of a bad month.
If you are borrowing for a house deposit, mention the loan to the mortgage lender. Undisclosed borrowing that turns up in the affordability check is a serious problem, and lenders frequently require a gifted deposit to be genuinely a gift — with a signed letter saying so. Those two positions are incompatible, and finding out at the wrong moment can cost the purchase.
When it is not repaid
A written note makes each of the options available. Without one, only the first is.
- 1
Ask, once, in writing
Short and factual: the amount outstanding, the schedule agreed, and a proposal. Keeping it in writing is not aggression — it is the record that lets you use any of the later options.
- 2
Vary the terms formally
If they genuinely cannot pay, a written variation extending the schedule is far better than an informal understanding. Sign it the same way you signed the original.
- 3
Get the debt acknowledged
A debt acknowledgment restates the outstanding balance as at a date and restarts the limitation clock. This matters — claims expire, and a loan repayable "whenever you can" can become unenforceable through the passage of time alone.
- 4
Send a formal demand
A demand letter setting out the facts, the sum, a deadline and the consequence. This is the last cheap step, and with family it is often the point at which the matter is finally discussed properly.
- 5
Decide about the relationship
Small claims procedures exist and are designed to be used without a lawyer. Whether to use one against a relative is not a legal question. Many people write the debt off deliberately — which is a legitimate answer, and a better one when it is a decision rather than a drift.
The one-paragraph version
Write down the amount, the schedule and the interest rate — even if the rate is zero and you say so expressly. Both sign it, both keep a copy. Charge the applicable federal rate if the loan is over $10,000, or accept the imputed-gift treatment knowingly. Say what happens if you die before it is repaid. That is fifteen minutes of work, and it is the difference between a loan and an argument nobody can win.
Sources
General information, not legal advice. This guide explains how these documents and rules generally work. Law varies by jurisdiction and changes, and none of it is applied to your circumstances here. For anything consequential, consult a licensed attorney where you are.
Frequently asked
Is a promissory note legally binding between family members?
Yes. A promissory note is an enforceable contract regardless of the relationship, provided it identifies the parties, states the amount and the repayment terms, and is signed by the borrower. Courts do not apply a lower standard because the parties are related — if anything, documentation matters more, because the alternative characterisation of the transfer is a gift.
Do I have to charge interest on a loan to my child?
Not always. Under US rules, gift loans between individuals of $10,000 or less are generally outside the below-market loan rules, so an interest-free loan at that level is straightforward — unless the money is used to buy income-producing assets. Above that, if you charge less than the applicable federal rate, the forgone interest is imputed to you and treated as a gift to the borrower. State the rate in the document either way.
What is the applicable federal rate?
A set of minimum interest rates the IRS publishes each month, in short-term, mid-term and long-term versions depending on the length of the loan. Charging at least the AFR for the relevant term keeps the loan outside the below-market rules. Take the figure from the IRS for the month you sign — the rates move, and an out-of-date number in your document is worse than none.
Can I forgive a family loan later?
Yes, and forgiveness is treated as a gift of the outstanding balance at the moment you forgive it, with whatever gift-tax reporting that requires. Some families forgive incrementally, up to the annual gift exclusion each year, which needs to be documented as it happens. Whichever route, record it in writing and tell whoever is drafting your will.
What happens to a family loan if the lender dies?
Unless the document says otherwise, the debt becomes an asset of the estate and the executor generally has a duty to collect it — which can mean pursuing a sibling. If you intend the loan to be forgiven on death, say so expressly in the note and deal with it in the will as well. Handling it in only one of the two documents is where the conflicts start.