Families lend to one another all the time — a parent helping with a down payment, grandparents covering a tuition shortfall, a sibling floating cash after a layoff. The appeal is mutual: the borrower skips a bank's fees and credit checks, and the lender earns more than a savings account pays. But goodwill alone does not make a loan legally sound or tax-compliant. Handled carelessly, a family loan can saddle the lender with an unexpected tax bill and end in a lasting rift. Here is how to do it properly. (This is general information, not legal or tax advice — consult a professional for your own situation.)

Put it in writing

The foundation is a promissory note — a signed, written promise by the borrower to repay a set sum on agreed terms. It should state the amount, the interest rate, the repayment schedule, the maturity date and what happens on default. A lawyer can draft one cheaply; templates are widely available.

The note matters because the IRS looks at whether a transfer is genuinely a loan or a disguised gift. The factors it weighs are familiar: Is there a signed note? Is interest charged? Is there a fixed repayment schedule — and is the borrower actually paying? One thing reliably destroys loan status: if there is any up-front understanding that repayment will simply be forgiven, the IRS can treat the whole sum as a gift from the start.

What a lien is, and when to use one

For a large loan — most often one used to buy a home — the lender may want collateral. A lien is a legal claim against an asset, usually real estate, giving the lender the right to be repaid from the proceeds if the property is sold or foreclosed. In a family mortgage, it is created by recording a mortgage or deed of trust with the county, alongside the promissory note.

A recorded lien does more than provide security. It establishes the family lender's priority over other creditors, and it lets the borrower deduct mortgage interest on their taxes — a deduction unavailable on an informal, unrecorded loan. The trade-off is real: the lender now holds a formal legal claim against a relative's home, which adds friction if the borrower later wants to refinance or sell.

The minimum interest rate: the AFR

This is where family loans most often go wrong. To avoid being treated as a gift, most family loans must charge at least a minimum interest rate — the applicable federal rate, or AFR — which the IRS sets every month based on Treasury yields. There are three tiers by loan length: short-term (up to three years), mid-term (three to nine) and long-term (over nine).

Because the AFR tracks Treasury yields, it has typically run well below mortgage rates — in mid-2026 the AFRs sat in roughly the 4%–5% range, against average 30-year mortgage rates closer to 6.5%–7%. That gap is why a compliant family loan can still be a meaningfully better deal for the borrower than a bank. The exact figure changes monthly, so check the current IRS table before setting your rate.

Imputed interest: the trap of charging too little

If you charge below the AFR — or nothing at all — the IRS applies imputed interest. Under Section 7872 of the tax code, it treats the lender as if they had received interest at the AFR even though no cash changed hands, and treats the shortfall as a gift to the borrower. Both sides can face consequences.

Two exceptions soften this:

  • The $10,000 rule. If total loans between the two people never exceed $10,000, the imputed-interest rules generally do not apply — unless the money buys income-producing assets.
  • The $100,000 cap. For balances between $10,001 and $100,000, imputed interest is capped at the borrower's net investment income for the year. If the borrower has little or no investment income, little or no imputed interest arises.

Gift tax, in brief

Even a clean loan can brush against gift rules if the lender later forgives payments. The annual gift tax exclusion lets you give each recipient up to a set amount per year with no gift-tax return and no dent in your lifetime exemption — $19,000 per recipient in 2026 ($38,000 for a married couple giving together), per the IRS.

Some families lean on this: they charge the required AFR interest, then separately gift the borrower an amount equal to that interest each year. It is legal, but the lender still owes income tax on the interest received, and any gift above the annual exclusion must be reported (on Form 709) and draws down the lifetime gift-and-estate-tax exemption — which stands at $15 million per person in 2026.

The risk no spreadsheet shows

Advisers consistently flag the same underrated hazard: what an unpaid loan does to a relationship. The Consumer Financial Protection Bureau suggests treating a family loan like any financial contract — with clear terms, documentation and a plan for the unexpected. A few habits help:

  • Set repayments the borrower can realistically meet before anyone signs.
  • Document every payment, ideally through a separate account.
  • Agree up front what happens if the borrower loses income — a written payment-pause clause beats an informal nod the IRS might later read as forgiveness.
  • Consider whether a smaller loan paired with an outright gift fits better than a loan alone.

Bottom line

Done right, a family loan helps a relative at a lower cost than a bank while earning the lender modest interest. Done sloppily, it invites IRS scrutiny and family friction at once. The minimum kit: a signed promissory note, a rate at or above the current AFR for the term, a realistic schedule, and actual documented payments — plus a recorded lien if real estate is involved. Given the tax wrinkles, an hour with a CPA or estate-planning attorney before signing is usually money well spent.