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I am writing up a legal document (USA, Michigan) for loaning 7k to a friend with 10% APR with a term length of 5 years. (known him 5 years, he has paid back many smaller loans before).

We'll both sign it with a bank notary.

What legal terms should I include to cover myself, and he wants to pay off large lump sums when he gets it (1000/2000 at a time). How would I apply those non-standard payments to ensure I am still getting 10% interest.

I think he wants anything over ~150 (avg monthly payment for 7k at 10% for 5 yrs) to go straight to principal but I want to be making a constant 10% interest

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    Since you asked for advice: don't loan it unless you plan on never being paid back. – Pete B. Jul 24 at 14:24
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    Define "constant 10% interest". If they make a lump sum payment, you're still making 10%. It's just 10% on a smaller chunk now. – ceejayoz Jul 24 at 14:26
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    @Jonast92 Some loans include a "prepayment penalty". Doing that to a friend might be perceived as particularly rude, though. – ceejayoz Jul 24 at 14:29
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    A first question that you should ask yourself is why your friend does not get a credit from a bank, and if it because the bank will not give one, consider if the reasons that the bank might have could apply to you. Keep in mind that for a bank giving a loan is less risky than you giving a loan; banks diversify their loans so someone defaulting is not a big hit, and banks have the know-how of getting people to pay if they are unwilling to (they have in-house lawyers that are considerably cheaper than you hiring a lawyer, for example). – SJuan76 Jul 24 at 15:25
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    @SJuan76 has a great point - evidently the bank considers this individual too risky to give them a loan at 10% APR, otherwise they wouldn't need a loan from a friend. This transaction is even riskier for you, so logic suggests that you should be charging them more than the bank. You should realize that according to the bank's actuarial tables, the profit you stand to make is not worth the risk of not being paid back. From a personal perspective, is the profit you stand to make worth the risk of losing this friend? – Nuclear Wang Jul 24 at 15:38
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As you have surely realized 10% amounts to less income as the principal remaining on the loan is paid back reducing the lender's overall income. But, you must keep in mind that non-payment is a possibility. Notwithstanding your friend's reliability this friend may get hit by a bus. Generally, you would want to seek a lien on some piece of property for the duration of the loan. With that said, it is in your best interest by miles to recoup your principal as soon as possible; early repayment is the best possible outcome even though it means less total interest income (which is taxable in the US).

In Michigan, as in many other states, there may well be regulations that limit the interest rate, compounding nature, and allowable fees of personal loans. Some jurisdictions may only allow simple interest, meaning interest cannot be calculated against accrued interest. These anti-loan-sharking laws.

I have seen simple interest loans where the annual interest is calculated as soon as the loan is issued and annually at the loan anniversary. This way, as soon as the loan is issued, $7,700 is due. Then if your friend pays you $3,000 through the year, at the anniversary of the loan the total outstanding is $4,700 making the total amount owed by the end of year two $5,170 ($4,700 + $470). In these arrangements where interest is only calculated once at the beginning of a year, expect to only receive payment on the last day of the year as there is no incentive to pay earlier.

You could use an adjustable rate loan where you adjust the rate each year to approximate a 10% overall yield. But this is needlessly complex in my opinion.

The award limit in Michigan small claims is $6,000. All you really need between you and a friend is a signed piece of paper saying the money is owed. In the worst case scenario you take that piece of paper to small claims court and get your $6,000, unless the amount remaining at the time is below that amount, award and try to collect against it.

I really can't stress enough that as a lender, particularly when your outstanding loan risk is so specific, your primary main objective is getting your money back. You are not a bank. Your tolerance for default is zero. Getting back your original $7,000 is WAY more important than ensuring you earn $2,000 in interest rather than $1,500 (or whatever).

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You’ve only known this individual for 5 years. I understand that it’s a friend and I’m sure it’s a relationship you care about. But, speaking from experience, (and forgive my frankness) there is absolutely no upside to loaning money to a friend. 10% interest is not worth putting unnecessary stress both on you personally and on the relationship.

If you are dead set on doing this. PUT COLLATERAL INTO THE EQUATION. There is a reason you see “title loans” advertised to people with bad credit scores. This means a bank will lend money to a questionable individual using their vehicle as a way of collateralizing the debt.

I seriously recomend forgetting about the interest and worry about making sure you are made whole. Without he/she being a family member or posting collateral, this is not a good idea.

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Use excel/LibreOffice function XIRR and then use "Goal seek"

  • Did you mean to put this as an answer to a different question, perhaps? – AakashM Jul 25 at 8:23
  • @aakashm , I very well to intend to answer this question, I will elaborate later. – Neil Jul 25 at 20:10
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For the legal jargon I would refer to an online legal document generator. There are many free (or cheap) form generators available that should be sufficient for your needs. But regardless of what the document says, you should only do this if you really trust the person will pay you back. Going to court is a hassle even with a signed agreement, especially if the person isn't paying because they simply don't have any money.

As for the financial aspect, I believe there is a simple way to accomplish both of your goals (extra payments go towards principal and you potentially maximize your interest). Here's how it works:

You will need a payment calculator that enables you to run payments based on a number of months (not years), and also shows you the amortization table, such as this one. At the beginning of each month:

  1. Reduce the total loan balance by (payment amount - last month's interest charge)
  2. In the calculator, enter in the remaining loan balance, the number of months remaining, and 10%.
  3. The resulting payment amount is the new minimum amount due that month.
  4. Show the amortization table to see how much interest you will charge for this month (which is subtracted in step 1 of the next month).

Note you don't actually have to run this calculation every month; you only need to run it in the months where an over payment was made (extra principal paid).

For examples:

Start of loan (Month 0):

  1. New loan balance = $7,000 - ($0-$0) = $7,000.00
  2. Enter into the calculator: $7K, 60 months, 10%.
  3. The minimum payment amount is $148.73 per month.
  4. Show the amortization table and note that $58.33 in interest will be charged this month.

If the minimum payment of $148.73 was made in the zeroth month, then (Month 1):

  1. New loan balance = 7000 - (148.73 - 58.33) = $6,909.60
  2. Enter into the calculator: $6909.60, 59 months, 10%.
  3. The new minimum payment amount is $148.73 (which is unchanged, as expected).
  4. Amortization table shows $57.58 in interest should be charged this month.

If a payment of $1000 was made in the second month, then (Month 2):

  1. New loan balance = 6909.60 - (1000.00 - 57.58) = $5,967.18
  2. Enter into the calculator: $5,967.18, 58 months, 10%.
  3. The new minimum payment amount is $130.16
  4. Amortization table shows $49.73 in interest should be charged this month.

Note that most banks don't lower your minimum payment on term loans like this (though some do), but the advantage of offering it is that you can continue to maximize your interest earned over the 5 years. (Which is why I used the word "potentially" in the first sentence of this answer.) But if you would rather the loan simply end sooner when over-payments are made, then set the minimum to be the initial amount of $148.73 and never lower it. You would still run the calculations as described above, but you skip step 3 after the zeroth month, meaning more principal will be paid each month. You could even let your friend choose which he prefers if you don't care. If I were in your friend's shoes I would prefer the option of the lower payment, but I would strive to always pay at the least the initial minimum amount, if not more. (But in a tight month it's nice to have the option of the lower minimum.)

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From my (limited) experience: either "lend as a friend" with minimal (if any) paperwork, and little or no interest (perhaps a simple fixed sum added to the original amount), or don't do it at all.

  • If you don't know/trust them enough to believe they will do their best to repay (even in the absence of a contract), don't lend.
  • If, because of their circumstances, the chance of them not being able to repay (even though they want to) is too high, and you are not prepared to write-off the loan should this happen, don't lend.

If either of the above apply, having a contract may allow you to start legal action, but (especially in the second case), the chances of actually recovering your money could be slim. The friendship will be wrecked in any case.


Many people on here (rightly) warn of the dangers of lending to friend/relative in case they are either unable to, or decide not to, pay you back. Even if you have everything sewn-up with a legally-watertight contract, the chances are there will be little money that you can recover. And whatever happens (after non-payment), the friendship/family-relations will never be the same again.

On the flip-side (and I recognize this is only one anecdotal reference point), I have twice successfully lent to a friend/relative with no problems. The people involved were not a close "blood tie" (part of my brother's wife's family), but people I knew reasonably well and who both had decent jobs. The first loan was for £5,000 to help with the deposit on a house where "time was of the essence" and they didn't have enough ready-cash available. The second loan was for £10,000 to help towards their ideal wedding. The first was repaid exactly as planned, and the second is about 70% repaid with absolutely no expectations of any problem.

Before the first loan, I toyed with the idea of trying to draw up some form of legal contract. Advice I saw at the time (before I came to PF&M) varied between "have it in writing in case the worst happens" to "if the worst happens, having it in writing is not worth the paper it's written on".

In the end, I didn't bother with a contract. I made a judgement-call that the chances of being paid back were high, and while I didn't immediately "write the money off as a gift", I could survive financially if it weren't paid back (the relationship, however, would be soured whether or not I had a contract). I simply lent the money "as a friend", without interest, hoping (and expecting) it would be paid back.

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In your agreement you can state that the 10% interest would be added to the loan on the 1st of every month at midnight, and that the interest would be based on the total balance of the loan at that point in time. So it would be [current total balance * 0.1 / 12] every month. Because any overpayments would reduce the total balance, then this would automatically reduce the interest payments for the following month. In my experience of bank loans in the UK this is how it seems to be done usually.

In the UK its also possible for banks to keep charging interest on overpayments for a limited number of days (I think 56 days) after the overpayment is made, however its up to the bank whethery they include this in their loan terms or just stop adding interest immediately for the overpayment.

  • This is the correct way to do an interest only loan (where the minimum payment is the accrued interest per month), but you may want to mention that some minimum principal amount (either fixed or variable) must be paid on top of that to make it a term loan. (Which then makes it basically the same as my long-winded answer, except that you provided a nice concise interest calculation. I'm giving you +1 just for that.) – TTT Jul 26 at 13:45

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