Lending Someone Money? Read This First.

When it comes to business (or life), nearly everyone has needed investment from an outside source at one point. A national survey said that 38% of startup businesses relied on money from family or friends. You may have started with a small loan from the bank, your parents, or an investor who thought you had a fantastic idea. That person’s investment slowly grew over time, and you’ve paid off your debts. Now you’re fortunate enough in your business that investing in someone else is a possibility. If you’ve moved on from the borrower side of things, and are looking at becoming the lender, there are definitely a few things to consider before you begin. 

1. Your relationship with your borrower will change, whether you began as business partners, friends, or family. Plan for this to happen. Adding money into any relationship fundamentally changes the dynamics of that relationship. The borrower will, at the very least, have financial rules to follow, and they may feel as though you have leverage over them. Relationships built over years or even decades crumble when conditions of a loan agreement are ignored or broken. 
2. Get your loan agreement in writing. Verbal contracts have proven to be unenforceable many times, and people’s memories are terrible, especially when it can benefit them in any way. When agreeing to loan money to anyone, all information and terms must be documented in writing. I have a sample promissory note on my website here. In New York State, a promissory note does not have to be notarized.
3. Charge a reasonable interest rate when lending money. An investment is just that: an investment! At the very least, you need to charge typical inflation rates over the term of the loan so that your money is not losing value. You also need to keep in mind the applicable federal rate, or AFR (the minimum market rate for loans.) At current rates, you need to charge your borrower a minimum interest rate of 2.72% for the loan. Any rate below the 2.72% could trigger a taxable event. 
4. Don’t charge too high of an interest rate. In New York State, charging interest of more than 16% per year is civil usury (the illegal action or practice of lending money at unreasonably high rates of interest). Furthermore, in New York, charging, taking, or receiving interest of 25% or more is criminal usury. This means that if you charge too high of an interest on your loans, you as the lender can get in trouble and won’t be able to force the borrower to repay the amount due.
5. Keep your taxes in mind. For loans in amounts less than $10,000, neither the lender nor the borrower has to report anything on their tax return. But if you loan someone $10,000 or more, you have to report the interest that you are expected to earn from the loan. This is where AFRs, the IRS minimum interest rates mentioned earlier, come into play. If you don’t charge at least that much interest, the IRS could make the interest you should have charged taxable to you.
6. Consider asking the person to whom you’re loaning money for collateral. As the lender, you want to have some sort of reassurance that the borrower will repay the loan. If the borrower gives the lender a piece of collateral, such as a valuable item or family heirloom, this means that the borrower has something at stake to discourage them from not paying back the loan. If the borrower doesn’t pay it back, you can get a court order to sell off the property, for instance, and get most of your money back that way.
7. Be very explicit about the repayment terms. Provide a minimum payment amount and specify when the money is to be paid. Are you being repaid in monthly installments over a set period of time or a lump sum on a certain date? What happens if they miss one payment? Spell out what happens if you were to die before the loan is repaid: Will it be forgiven, owed to your estate, or subtracted from that person’s share of inheritance? What happens if they want to prepay?
8. Be absolutely sure you want to lend money to this person. If the other party does not follow through with their end of the deal, and you’re out the $10k they owe — are you prepared to take this person to court? It could be your own brother, and you’ll have to take them to small claims court, get a judgment and then pursue collection activities on the loan (like a wage garnishment or property liens), just like the other creditors. 
9. Keep communication open. Your borrower could make periodic updates for you to discuss the business, good or bad. It helps to know in advance that there might be problems paying the loan. Financial trouble happens sometimes, and both the borrower and the lender should be realistic about what is expected. The borrower should make repaying the loan a top priority. The lender should expect some problems, but they need to be resolved in a timely and appropriate manner. 
10. Be firm in your agreement. While it’s a nice gesture to loan someone money, it’s also something that should be done with caution. At the end of the day, it’s a business decision. If you do move forward with the loan, you will have all of these considerations to keep in mind. If things don’t work out, you may need to get an attorney and go to court, so make sure the business terms of your loans make sense and everything is written down.