Loans: The Essential Guide to Lending Money

Last updated January 8, 2024

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Bringing money into a personal relationship can quickly make things complicated.

But here’s good news. With the correct documentation, clear communication, and legal compliance, loaning money to friends and family is a breeze. With only a few simple steps, you can ensure that your interests and finances are protected when loaning money to loved ones.

In this guide, we’ll cover everything you need to know about lending money, including safeguarding your finances, effectively using Promissory Notes and Loan Agreements, and more.

Here’s the thing: lending money is a practical decision, not an emotional one. Although you might feel obligated to offer a loan to a loved one, you must put yourself and your financial interests first. 

Will this loan impact your retirement plans? Do you trust the borrower? Are you comfortable with potentially never getting this money back? These are all questions you should ask yourself before lending money. 

Read on for 3 key considerations before you make this financial decision. 

1. Do you trust the borrower? 

No matter what, loans are a risky decision. You are agreeing to surrender a portion of your finances to another individual and putting faith in them to return your money. Make it easier on yourself by only loaning money to people you trust. 

Ultimately, who you trust is a personal decision. There’s no foolproof way to determine who is (or isn’t) trustworthy. However, there are still a couple of things that you can look for when determining an individual’s reliability.

• Positive past experiences: Ask yourself–has the borrower proven their dependability in other circumstances? Have they made commitments or promises to you in the past? Have they followed through? If yes, then you may choose to use this evidence as a good sign and proceed with the loan. If not, then it might make sense to reassess. 
• Favourable secondhand stories: If you and the borrower have a mutual acquaintance, you could ask this third party for their opinion. Depending on what they say, you can make a more informed decision on whether or not to pursue the loan. 
• A good financial track record: Has the borrower had other personal loans in the past? Have they re-paid these loans promptly? We’ll talk more about assessing the borrower’s financial standing in the next step. 

While you may trust friends and family with personal issues, it’s important to consider how they handle financial matters. Lending to someone just because you love them has downsides, especially if they are unreliable with money. Consider the impact a loan will have on your personal relationship, especially if your loved one fails to repay your loan. 

2. What’s the financial standing of the borrower?

So your borrower is reliable, responsible, and accountable when it comes to personal matters. That’s a good sign, but it is not enough. In order to effectively protect their finances, lenders must consider the borrower’s financial history. 

The easiest way to understand a borrower’s financial situation is by asking to see a Personal Financial Statement. This document will summarize the borrower’s current financial position and give you a sense of their total net worth. Financial Statements typically include information about: 

• Assets: cash, bank and brokerage accounts, retirement savings, investments, land without liens, income streams, business inventory, and any special items of value. 
• Liabilities: credit card debt, car loans, mortgages, unpaid taxes, child support payments, and any other debt/liabilities. 

3. What’s the financial standing of the lender? 

Now that you’ve determined that the borrower is a good candidate for a loan, both personally and financially, it's time to examine your own finances. With the lasting impacts of the COVID-19 pandemic and rising costs of living, it is important to be realistic. If you are already struggling to make ends meet with your paycheck, then loaning money probably isn’t the wisest idea.

Be honest with yourself: can you afford to lend money? 

When considering a loan, it pays to put yourself first. If lending money to a loved one will jeopardize your retirement plans, chances are that the risk isn’t worth it. Similarly, if you have to borrow money in order to lend money, it may be worth reconsidering.

Limit the loan amount to what you can afford. Be honest about your money situation instead of risking your own interests to keep a good relationship with the borrower. A good rule of thumb is to only loan what you can afford to lose. In the worst-case scenario, you might not see this money again.

Now that you’ve carefully considered the implications of loaning money to a loved one, you are ready to proceed. Next, we’ll outline 3 ways to ensure that your interests and finances are legally protected.

1. Get it in writing!

It may be tempting to rely on good faith when lending money to loved ones. But, when dealing with finances, relying on a verbal agreement is not enough. Having the terms and conditions of a loan laid out in a legal document like a Loan Agreement or a Promissory Note protects both you and the borrower in case of misunderstandings down the line. 

Loan Agreements: Comprehensive, traditional, and enforceable.

A Loan Agreement is a contract between a borrower and a lender that specifies the terms and conditions of a monetary loan. 

Loan Agreements are beneficial for many reasons. They:

• Document the loan’s terms 
• Prevent misunderstandings
• Outline a repayment plan
• Create a plan of action for if the borrower defaults on the loan 

 A Loan Agreement typically includes the following information:

• Your information
• The borrower’s information
• The loan amount
• Interest and late fees
• A repayment plan
• Collateral terms

Promissory Notes: Less formal, still legally binding. 

Just like Loan Agreements, Promissory Notes document a loan’s terms. However, Promissory Notes are less formal than Loan Agreements. They are traditionally used by unconventional lenders for loans outside of traditional institutions, such as agreements between family members. 

Promissory Notes typically include the following information:

• Your information
• The borrower’s information
• The loan amount
• Interest and late fees
• A repayment plan
• Collateral terms

2. Be clear about the loan’s terms and conditions

You might think that this step goes without saying. However, reviewing all terms and conditions of a loan is a crucial step that helps prevent misunderstandings. In addition to discussing the loan amount, this conversation should also include the finer details of the loan, including: 

• The interest rate
• Repayment schedule
• Collateral details (if applicable)

When considering granting a loan, remember that there are typically two types of loans: 

1. Secured loans, which use an asset like a house or car (i.e., collateral) to ensure that the loan is repaid. 
2. Unsecured loans, which do not have any collateral. These loans are often approved based on a borrower’s credit score. 

3. Choose an interest rate and repayment schedule 

Once the terms of your loan are crystal clear, it's time to set an interest rate and draft a repayment schedule. 

Personal loans from friends or family members are often advantageous for borrowers since interest rates are typically lower than a bank or other money-lending institutions. Interest rates in Canada are regulated by the Canada Interest Act. 

It is up to you to set the interest rate on your loan. If no interest rate is set, Canadian regulations set it at 5% per year. Additionally, your interest rate cannot exceed 60% per year, which is viewed as a “criminal interest rate.”

Another way to make lending money easy on yourself is by clearly establishing a repayment schedule. Whether you prefer a lump sum on a specified date or smaller monthly payments spread over a year, outlining these terms in your Loan Agreement or Promissory Note is essential. Our templates include a built-in payment schedule, detailing periodic loan payments. If you and your borrower agree to an alternative schedule, you can adjust your agreement accordingly or create a separate Amortization Schedule.

Additionally, it's important to determine if there will be penalties for late payments. Imposing a late penalty, such as a fee or an increased interest rate, serves as an incentive for prompt payments. As the lender, you have the discretion to decide whether to enforce the late penalty. 

At the end of the day, clearly outlining both the loan’s interest rate and the repayment schedule will help to ensure that your money is returned in a timely manner.

In the worst-case scenario, you may need to take steps to collect if the borrower refuses to repay the loan. 

First, try sending a Demand Letter. This document is a final reminder to your borrower demanding payment. A Demand Letter is seen as the last warning before pursuing legal action. It also often sets a deadline for the recipient to resolve the issue. It is a good idea to attach your Loan Agreement or Promissory Note to the Demand Letter to further prove that the debt is owed to you. 

If your borrower still fails to repay the loan, it may be a good idea to pursue legal action. If your claim is under a certain financial amount, you can file in your province’s small claims court. For example, in British Columbia, individuals can file if their claim is under $35,000. However, each province has varying guidelines for filing in small claims court, so make sure to consult the regulations in your jurisdiction. 

Here’s a final thing to remember: there’s a time limit on when you can pursue legal action against the borrower. This is legally known as a limitation period. The length of a limitation period varies by province, but the general rule is that if there has been no payment or debt acknowledgment in more than 2 years, you may not be able to collect on the debt. If you have specific concerns about pursuing legal action, speak with a lawyer. 

Let’s recap: loaning money is simple if you confirm that the borrower is trustworthy, only lend what you can afford, and get all the loan’s terms in writing with a Promissory Note or Loan Agreement. With these simple steps, navigating a loan goes from daunting to manageable. 

Now it's your turn. Next time you lend money to a loved one, just remember that financial matters require a mix of compassion and clarity. By being realistic, communicating openly, and getting everything in writing, you can ensure that your relationships stay strong, while your financial boundaries remain intact.