During tough economic times, with many people dealing with the burden of debt from student loans and mortgages, more and more individuals are opting to borrow money from friends and family members. According to a recent online poll by consumercredit.com, 82% of respondents would lend money to a family member that needs it, and 66% of people would be willing to give money to a needy friend.
It can certainly be difficult to say no when you see someone you care about struggling financially. The question is, if you choose to lend them money how can you ensure they pay you back? The following article describes three different ways to put the loan down in writing so you are not only both crystal clear about the terms of the agreement, but are also legally protected.
Table of Contents
1. AN IOU FORM
2. A PROMISSORY NOTE
3. A LOAN AGREEMENT
1. AN IOU FORM
What it includes
- Amount owed
- Due date of loan
- Name of lender (signature not necessary)
- Name of borrower (with signature)
When to use it
- If a close friend or family member asks to borrow money
- If you’re looking for some form of documentation that’s not too formal
What makes it different
- The simplest and least formal of the three forms
- Only the borrower’s signature is needed
Sam and Jake: A Common IOU Form Scenario
A BALMY SUMMER EVENING
Sam is sitting in his dusty apartment, taking apart a clock he once loved (yet also secretly despised) so he can use the cogs for a solar powered watch idea he’s been developing since the 90’s. The screen door at the back of his house swings open, slamming repeatedly into the timber siding. Standing there is Jake, with his distinctive beard and red checkered flannel shirt. Jake’s a long time friend and distant cousin (although neither of them have no idea how they are related whatsoever).
THE USUAL REQUEST
Sam sits in his dusty apartment, taking apart an old clock he once loved. He had plans of using the cogs for a solar powered watch idea he’s been developing.Behind him the sound of his screen door swings open and slams repeatedly into the timber siding. Without needing to turn around, Sam knows who has just walked in, maybe from years spent together at awkward family gatherings. It was his cousin Jake, with his lumberjack beard and the mess of bedraggled hair he shoved into a stocking cap.
“Hey there, Sam,” Jake grunts.
“What can I do ya for?,” Sam asks, knowing well that Jake probably needs something.
“Well, cousin, I’m in a bit of a pickle,” Jake mumbles through his hand stroking as it searches for stray crumbs in his beard. “Margaery wants a new storage shed, and I just
ain’t got the funds.”
“How much you need?”
“A couple grand would do me,” Jake replies.
‘Ah, it just keeps going up’, Sam thinks to himself.
Over the past few years, he has lent ol’ Jake thousands of dollars, each time the amount getting a bit bigger. Sam doesn’t bat an eye. The previous “loans” had never been paid back. Jake shifts his weight to his right leg, the left one still aching from the bike accident he had a few weeks ago.
Sam looks up at him. “Ok, Jake,” he shrugs and mumbles. “But this time, we are putting it on paper.”
Jake raises his bushy eyebrows in surprise. “Well, alright then.”
THE FINAL DECISION
Sam finally decided to take his finances in his own hands. His deadbeat cousin put him into a tough position, after refusing to pay for prior loans for years (unless you consider a beer or two at the pub on a Saturday afternoon).This is a likely scenario for many people who have the trust of friendship as the only motive to pay money back. But sometimes, that just isn’t enough.
2. A PROMISSORY NOTE
What it includes
- Amount owed
- Due date of loan
- Name of lender (signature not necessary)
- Name of borrower (with signature)
- Installment dates and payments
- Collateral terms
- Interest charged (if any)
When to use it
- If you’re investing in a business, paying for medical expenses, credit card debt, fees for child adoption or a special event like a wedding
- If you think the other person may not pay and you need to secure collateral
- If you think they might need to pay you back in installments
- If you want to charge them interest on their loan
What makes them different
- There are 2 types: Secured and Unsecured Promissory Notes
- Secured Promissory Notes involve collateral terms (items that the lender can take if the borrower doesn’t pay)
Crystal and Mike: A Common Promissory Note Scenario
A LONG, HARD DAY
Mike pulls up to the front of his house in a battered, red pickup truck after a late night at work. Lately, he’s been working long hours on sale’s deal for electric scooters with a client from Shanghai. He opens the door and is suddenly invigorated by the smell of dinner – an eggplant parmigiana pizza covered with nut cheeses on a gluten free base. His wife, Crystal, has a lot of spare time nowadays working part time in online sales where she peddles three-wheeled baby strollers to upper middle class folk across the globe.
“Hey, hun!” Mike says and kisses her on the forehead. She is covered (as the entire kitchen seems to be) in some sort of buckwheat-quinoa-something-hipster flour.
“Hey babe,” he replies, “check out this parmigiana! I actually ground down the flour from roasted buckwheat and the grinder was all like…..”
He tunes out and her voice trails off into the distance. He’s become accustomed to this thirty minute spiel every time she cooks dinner, which happens to be every evening the last few months since she’s been working from home. Mike receives an unexpected and unwelcome request.
“… two-thousand dollars.”
THE PRICE OF QUINOA JUST WENT UP
His attention suddenly re-enters the conversation at the word “dollars”.
“Sorry, what?”
“I need to borrow two-thousand dollars,” she replies, as she gently glides a slice of pizza onto his plate.
“For what?” He glares over at her. It’s been a long day, and he is starving.
“I just told you. I need to get a new computer.” He never listens to me, she thinks, equally as agitated.Mike stops and thinks for a minute. He has the money in the bank, but the last time she borrowed from him, he felt guilty about asking for repayments and let the loan slide into oblivion.
MONEY CAN’T BUY YOU LOVE
“Ok, but will you pay me back?” he asks, already knowing the answer.
“Of course I will, darling.! I can pay it back, like, every month over the next six months. We can even get it writing if you don’t believe me.”As if he would ever do that, she thinks.
“Ok, well if you don’t pay me back I’m taking your bike as collateral.” He’s not joking either.
Mike definitely needs to get her to sign a Promissory Note. He isn’t going to charge her any interest this time, but he could use this form again in the future if needed, keeping both of them in the clear about the terms of the agreement.
3. A LOAN AGREEMENT
What it includes
- Amount owed
- Due date of loan
- Name of lender (signature not necessary)
- Name of borrower (with signature)
- Installment dates and payments
- Collateral terms
- Interest charged
- Consequences of defaulting (if payer doesn’t pay, what happens)
- Late charges that could be incurred
- Prepayments (including discounts if the borrower wants to pay in advance)
- Joint and several liability
- Right to transfer (if the lender wants to transfer the loan to someone else).
When to use it
- When there is a substantial amount of money involved in the loan
- If you want to charge the borrower late fees if make late repayments
- If you want to include the consequences of defaulting (e.g collateral repossession, enlisting a debt collector and/or the filing of a lawsuit against the borrower).
- If you need capital to start a business, purchase a home, repay a student loan or buy a new car for yourself or someone else.
What makes them different
- The most formal and detailed of the three types of loan agreements
- Can include joint and several liability; all borrowers are responsible when one doesn’t pay
- Can include consequences of defaulting; what happens when the borrower doesn’t pay
- Any late charges that could be incurred
- Prepayments; including discounts if the borrower wants to pay in advance
- Right to transfer; If the lender wants to transfer the loan to someone else
Grandpa Joe and Tessa: A Common Loan Agreement Scenario
Tessa laughs gleefully as she squeezes her cat, Fluffy, with all her might. Fluffy is now almost fifteen years old and still manages to run like a lightning bolt whenever Tessa arrives at Grandpa Joe’s house. Tessa lives in New York City but loves getting out of The Big Smoke to visit her grandpa on the weekends. She helps out with the garden and happily listens to his stories about the war. As she reflects on those happy thoughts, one big looming one enters her mind: she wants to buy an apartment in Brooklyn but is coming up shy on the deposit.
TESSA DEFTLY SPRINGS A TRAP
“Did you always own this house Grandpa?” She asks hoping to bring up the conversation of home ownership. He walks in with a teapot and some cups. “Yes, we built it ourselves, your dad and I, when he was about your age.”
“No way! I can’t imagine dad building anything!” she laughs.
“Yep. We built it alright. With about thirty two thousand dollars, too!” he chuckles.
“Wow, that’s basically a deposit on some apartments nowadays…” Tessa pauses for a moment, considering exactly the best way to ask (she has practiced this in her mind several times over).
GRANDPA FALLS IN HAPLESSLY
“You know, grandpa, I’ve been thinking of buying an apartment for quite awhile now. I found the perfect place too! It’s just over in Brooklyn with the most gorgeous kitchen…”
She glimpses over at him, hoping he is getting her drift.
“Have you got a deposit yet?” he asks, knowing very well that she doesn’t. He’s been waiting years for this conversation.
In Summary
The type of written agreement you choose will depend on the circumstances of the loan and the relationship you have with the borrower. Whether the debt is for a small amount using an IOU form, or a larger amount with interest and collateral using a Promissory Note or Loan Agreement, it is critical you ensure the debt is set out in writing to give both of you a clear understanding of the loan terms and conditions.
For more information, read these articles if you need to enforce an existing Promissory Note, or are trying to collect a debt from a friend or family member.
