You agree to lend a relative $5,000. You both settle on a monthly payment. Someone suggests adding 6% interest, and that sounds simple enough.
But what does “6% interest” actually mean?
Is interest calculated on the original $5,000 for the entire loan, or only on the amount still unpaid? Does it accrue every day or once a month? If a payment is late, does interest keep running? If the borrower pays the loan off early, what happens next?
Those questions can produce different balances even when the annual rate is exactly the same.
If you decide to charge interest on a loan between relatives or friends, agreeing on the percentage is only part of the job. You also need to agree on how that percentage turns into dollars over time.
The goal is not to make a family loan look like a bank contract. It is to make sure both people understand the same deal before money changes hands.
Start with why you are charging interest
Before choosing a rate, talk about why interest is part of the arrangement at all.
A lender may want interest because the money will be unavailable for months or years, because they would otherwise keep it in savings or investments, or simply because both people believe paying something for the use of the money makes the arrangement more balanced.
The borrower may view it differently. A loan can still be helpful compared with other options, but the payment needs to remain affordable after interest is included.
There is no rule that every family loan should charge interest. What matters is that both people understand why interest is there and what it will cost.
The Consumer Financial Protection Bureau’s guidance on family lending and borrowing recommends discussing repayment expectations, what happens if circumstances change, and giving everyone a copy of the agreement.
”6% interest” can mean different things
Interest can be calculated in several ways. Before choosing a rate, decide which method you actually mean.
No interest
The simplest option is an interest-free loan. If someone borrows $2,000 and repays exactly $2,000, there is no interest calculation to manage.
That does not necessarily eliminate tax questions. Certain below-market family loans can still have federal tax consequences even when little or no interest is charged.
Simple interest on the remaining principal
With simple interest on the outstanding principal, interest is calculated from the amount of principal still unpaid.
If a borrower starts with $2,000 of principal and later reduces it to $1,500, future interest is based on $1,500 rather than the original $2,000.
Under a non-capitalizing simple-interest arrangement, unpaid interest does not itself begin earning interest. Interest is calculated on principal, not on accumulated interest.
The CFPB describes simple-interest loans as calculating interest based on the outstanding balance, commonly on a daily or monthly basis. Its explanation of simple versus precomputed interest is a useful overview.
For many loans between friends or relatives, this can be a sensible starting point because the basic idea is easy to explain: as principal goes down, the amount on which interest is calculated also goes down.
That is a reasoned preference for simplicity, not a universal rule.
Compound interest
With compound interest, accumulated interest can itself become part of the amount on which future interest is calculated.
Investor.gov defines compound interest as interest earned or charged on principal and accumulated interest.
Compound interest is not automatically unfair. It simply requires more detail. The agreement should say when compounding occurs and under what circumstances unpaid interest is added to the balance.
Precomputed or add-on interest
With precomputed interest, some or all of the interest obligation is calculated in advance based on the original amount, rate, and expected term.
That can make early repayment behave differently from an outstanding-balance simple-interest loan. The exact result depends on the agreement and applicable rules, so do not assume every precomputed loan handles early payoff the same way.
Simple, fixed and amortized do not mean the same thing
These terms describe different parts of a loan.
Simple versus compound describes what interest is calculated on.
Fixed versus variable describes whether the interest rate itself stays the same.
Amortization describes how repayment happens over time.
A loan can therefore have a fixed 6% rate, use simple interest on the remaining principal, and also have an amortizing monthly payment schedule.
Write down how the loan actually works
Once you choose an interest method, document enough detail that either person could look at the loan six months later and understand how the current balance was reached.
For a broader recordkeeping checklist, see what to write down before lending money to a friend.
At minimum, agree on:
- Original principal: How much is being lent?
- Annual interest rate: What percentage applies?
- Fixed or variable rate: If it can change, how and when?
- How interest accrues: Daily, monthly, or another method?
- Accrual start date: When does interest begin?
- Payment amount and timing: How much is due, and when?
- Payment allocation: Does a payment cover accrued interest first and then principal, or follow another rule?
- Expected end date: When should the loan be paid off if payments occur as planned?
- Early repayment: Can extra principal be paid? What happens if the loan is paid off early?
- Missed payments or pauses: Does interest continue to accrue?
- Fees: Are there any late fees or other charges?
- Capitalization: Can unpaid interest ever be added to principal?
- Rounding: How are fractions of a cent handled?
- Changes: How will later changes to the agreement be recorded?
A missed payment or agreed pause does not automatically mean interest stops accruing. If interest is supposed to stop during a pause, say that. If it continues, say that too.
Hypothetical example: daily simple interest on remaining principal
Consider this teaching example.
A relative lends another relative $2,000 on December 15, 2023. They agree to:
- a 6% annual rate;
- daily simple interest on outstanding principal;
- the actual number of elapsed days;
- a 365-day denominator for days in a normal year and 366 for days in a leap year;
- payments applied first to accrued interest and then to principal; and
- accrued interest rounded to the nearest cent when a payment is applied.
The borrower makes two $350 payments.
The 6% rate is arbitrary. It is not a recommended family-loan rate, a verified Applicable Federal Rate, a state-law interest limit, or a description of a particular Repaya loan.
First payment: January 15, 2024
There are 31 elapsed days since December 15. Because the period crosses into leap year 2024, 17 days fall in 2023 and 14 days fall in 2024.
Interest is:
$2,000 × 6% × (17/365 + 14/366) = $10.179205...
Rounded to cents, accrued interest is $10.18.
| Item | Amount |
|---|---|
| Opening principal | $2,000.00 |
| Elapsed time | 31 days |
| Accrued interest | $10.18 |
| Payment | $350.00 |
| Principal repaid | $339.82 |
| Closing principal | $1,660.18 |
The first $10.18 covers accrued interest. The remaining $339.82 reduces principal.
Second payment: February 15, 2024
Another 31 days pass. All of them occur in leap year 2024, so the denominator is 366:
$1,660.18 × 6% × 31/366 = $8.436980...
Rounded to cents, accrued interest is $8.44.
| Item | Amount |
|---|---|
| Opening principal | $1,660.18 |
| Elapsed time | 31 days |
| Accrued interest | $8.44 |
| Payment | $350.00 |
| Principal repaid | $341.56 |
| Closing principal | $1,318.62 |
The annual rate stayed at 6%, but the second period generated less interest because the outstanding principal was smaller.
This example also shows why the calculation method belongs in the agreement. Different payment dates, leap years, rounding rules, day-count methods, payment-allocation rules, or capitalization rules can change the result.
Do not overlook the tax side
For U.S. taxpayers, both charging interest and charging too little interest can have federal tax consequences.
Interest received may be taxable income
The IRS generally requires taxable interest to be reported even if the lender does not receive a Form 1099-INT.
That means a lender should not assume interest received from a relative is tax-free simply because no bank or financial institution is involved.
See IRS Topic No. 403, Interest Received and IRS Publication 550 for current federal guidance.
Below-market loans can create separate tax consequences
Federal tax law also contains rules for certain below-market loans.
IRS Publication 550 explains that, in some situations, forgone interest can be treated as though the borrower paid interest to the lender and the lender then transferred that amount back to the borrower. In family-loan situations, that deemed transfer can sometimes raise gift-tax questions as well.
These rules include exceptions and special limitations. That is why a single dollar threshold should not be treated as making every family loan “tax-free.”
One benchmark used in these rules is the Applicable Federal Rate, or AFR. The IRS publishes AFRs monthly, and the rates vary based on loan term and compounding period.
An AFR is a federal tax benchmark. It is not a universal recommended rate for family loans and is not a state-law interest ceiling.
Gift-tax filing and gift tax owed are different questions
Gift-tax filing requirements and whether gift tax is actually owed are not the same thing.
Debt forgiveness, or a deemed transfer created by certain below-market-loan rules, can raise gift-tax issues. The IRS separately addresses annual exclusions, filing requirements, the lifetime basic exclusion amount, and whether tax is ultimately due.
For larger or more consequential loans, professional tax advice can be worth getting before the money changes hands.
State law can matter too
Federal tax rules are only part of the picture.
Permissible interest rates, fees, documentation requirements, licensing rules, and other restrictions can depend on the jurisdiction and the type or purpose of the loan.
Professional legal or tax advice becomes more useful as the amount or complexity grows, especially for loans involving real estate, collateral, business use, significant tax consequences, or unusual repayment terms.
The most important test: can both people explain the deal?
After agreeing on the loan, both people should be able to answer the same question:
How will we know what is owed next month?
If one person thinks “6%” means interest on the original amount while the other expects interest only on the remaining principal, the agreement is not finished.
The same is true if one person expects interest to stop during a payment pause and the other expects it to continue.
Write down the calculation method along with the payment schedule. Keep a record of payments and agreed changes. Make sure both people can see the same information.
Repaya helps friends and family keep the loan balance, payment history, and next steps visible to both people. Whether you use Repaya, a spreadsheet, or another system, the useful part is having a record both people understand.
Family-loan interest checklist
Before money changes hands, review these questions together:
- Why are we charging interest, or why have we chosen not to?
- What is the original principal and annual interest rate?
- Is the rate fixed or variable?
- How is interest calculated?
- When does interest start accruing?
- What is the payment schedule?
- How are payments allocated between interest and principal?
- What happens with extra or early payments?
- What happens after a missed payment?
- During a payment pause, does interest continue?
- Are there any fees?
- Can unpaid interest ever be added to principal?
- How are rounding differences handled?
- What records will each person receive or be able to see?
- How will changes to the agreement be recorded?
- Is professional tax or legal advice warranted?
Interest does not have to make a family loan complicated. But the percentage alone is not the agreement.
Define how the interest works, make sure the payments are realistic, and write down enough that both people can arrive at the same balance later.