I'm not sure that there is a universally accepted "proper etiquette" when it comes to repaying a loan from a friend, but I feel it necessary to be absolutely fair in respect of the time value of money; and so, feeling this way, I see it fit to pay the principal and a fair interest amount. What is the standard approach among polite society for such a thing?
The standard approach is to reach an agreement and put it in writing. What you agree upon is up to you, but in the US if you want to avoid gift taxes larger loans need to be properly documented and must charge at least a certain minimal interest rate. (Or at least you must declare and be taxed upon that minimal income even if you don't actually charge it. Last I looked, the federal requirement was somewhere under 0.3%, so this isn't usually an issue. There may also be state rules.)
When doing business with friends, treat it as business first, friendship second. Otherwise you risk losing both money and friendship.
Regarding what rate to charge: That is something you two have to negotiate, based on how much the borrower needs the money, how much lending the money puts the lender at risk, how generous each is feeling, etc.
- One starting point for a fair rate would be to charge/pay a rate comparable to other investments with a similar degree of risk, since the lender will be giving up the gains this money would otherwise produce. One broker currently estimates long-term average return on bonds to be about 3.3%, so that's one possible definition of fair.
- Or you could use the rate of whatever mix of investments the lender will have to "break" to fund the loan. This may be higher than retail loan rates, but is still a reasonable definition of fair.
- Or you could argue that anything less than retail rates is by definition a bargain; that too is "fair" if the two of you agree it's fair.
- Or the lender may want to artificially reduce the rate, gifting the borrower with part or all of the interest; that too could be "fair" if it's what everyone is comfortable with.
Sorry, but there is no one-size-fits-all answer here. What I charge (or insist on paying to) my brother might be different from what I charge my cousin, or a co-worker, or best friend, or... If both parties think it's fair, it's fair.
If you can't reach an agreement, of course, the loan doesn't happen.