Rates have fallen since you set up the loan, and someone in the family has asked the obvious question: can we refinance a family loan the same way you'd refinance a mortgage? The honest answer is it depends entirely on how the original loan was structured, and most families get the mechanics wrong in a way that quietly creates a gift tax problem.
Here is the short version. If your loan is a demand loan, you do not need to refinance anything. The rate you must charge already resets every year to the IRS's blended annual rate, so it tracks the market automatically. If your loan is a term loan with a fixed payoff date, the rate is locked to the Applicable Federal Rate (AFR) in effect the month you signed it, for the life of the loan, full stop. To get a lower rate on a term loan, you cannot simply agree verbally to charge less. You have to properly re-paper the loan as a new note priced at the current month's AFR, or the gap between what you charge and the AFR becomes an imputed gift every year the old balance is outstanding.
Can you just agree to a lower rate on a handshake?
Section 7872 of the tax code treats a family loan that charges less than the AFR as a "below market loan." When that happens, the IRS splits the transaction into two pieces for tax purposes: the lender is deemed to have made a gift to the borrower equal to the foregone interest, and the lender is still taxed on phantom interest income at the AFR, whether or not they actually collected it.
That rule does not go away just because you both agree to a friendlier number. If you and your adult child shake hands and cut the rate on an existing note from 6% to 3% without doing anything else, and 3% is below the AFR that applied when you first signed the note, you've created an annual below-market loan gift, calculated on the new, lower rate against the original AFR, for every year the loan remains outstanding at that rate.
This catches families off guard because mortgage refinancing works differently. A bank can reprice your mortgage to today's rate because it is replacing the loan outright. A family loan modification only gets that same clean reset if it is treated, on paper, as a new debt instrument.
Why do term loans and demand loans follow different rules?
| Term loan (fixed payoff date) | Demand loan (payable anytime) | |
|---|---|---|
| Which AFR applies | The AFR for the loan's term, locked at the month of funding | The IRS's blended annual rate, recalculated each year |
| What happens when market rates fall | Nothing automatically. You keep the original rate unless you formally refinance | The required rate falls with it, with no paperwork needed |
| What happens when market rates rise | You keep your original, now-below-market rate for free | The required rate rises too; you must bump the charged rate to match |
| Best for | Lenders who want rate certainty over a multi-year loan | Lenders comfortable adjusting the rate annually in exchange for flexibility |
For current AFR figures by term, use the IRS minimum interest (AFR) calculator, which pulls the current month's published rates instead of a number that goes stale the next time the IRS updates them. Our guide to the Applicable Federal Rate covers how the IRS sets short-term, mid-term, and long-term AFRs if you want the mechanics behind the table.
How a term loan actually gets refinanced correctly
- Check today's AFR for the loan's remaining term. A loan with three years left uses the mid-term AFR for the month you refinance, not the short-term rate and not the rate from when you first signed.
- Draft a new promissory note or a written modification agreement that states the new rate, confirms it is set at or above the AFR in effect for that month, and references payoff of the old note's balance.
- Both parties sign and date it. This is what makes the IRS treat the change as a new debt instrument rather than a side letter lowering the price of the old one. Tax regulations on debt modifications (Treas. Reg. 1.1001-3) generally treat a sufficiently significant change in a loan's terms, including a material rate change, as if the old debt were paid off and a new one issued. For a family loan, that reissuance is exactly what lets you adopt this month's lower AFR instead of staying locked to the original one.
- Update the loan record you're tracking the balance against, so the amortization schedule, interest accrual, and remaining term all run off the new rate and the new signing date rather than the old one. If you're tracking the loan in Family Loan Tracker, use how to change your loan's terms to apply the update without losing payment history.
- Keep the paper trail. Both the old note's final balance and the new note's opening terms should be documented. If the IRS ever asks why the rate changed mid-loan, "we signed a new note at that month's AFR" is a defensible answer. "We agreed it was fine" is not.
A worked example
Say you lent your daughter $50,000 four years ago as a 7-year term loan at 4.8%, which was the long-term AFR that month. Rates have since dropped, and this month's AFR for a 3-year remaining term is 3.6%.
If you and she just start using 3.6% going forward without re-papering anything, the IRS's reference point is still the original loan's AFR at signing, 4.8%, because the loan was never legally modified. Charging 3.6% against a required 4.8% creates a foregone-interest gift of roughly $600 a year on the $50,000 balance, on top of whatever other gifts you make to her that year, counting toward your $19,000 annual exclusion per recipient for 2026.
If instead you sign a short modification agreement this month, priced at the current 3-year AFR of 3.6%, you are compliant at that new rate from day one. No imputed gift, no phantom interest income above what you're actually charging. The only cost is twenty minutes with a template and both signatures, not a trip to a bank.
When it isn't worth doing
Refinancing a family loan is a paperwork exercise, not a product you shop for, so the savings have to justify it. On a $15,000 balance, the difference between 5% and 4% is around $150 a year, likely less than what you'd pay an attorney to draft a clean modification if you don't do it yourself with a template. On a $150,000 multi-year loan, the same one-point drop is worth over $1,000 a year, which clears that bar easily.
If your loan is small, short-term, or close to payoff anyway, it is often simpler to just let it run at the original rate, or to forgive a portion of the balance within the annual exclusion instead of refinancing it. Our guide on how to forgive a family loan without triggering gift tax walks through that alternative, including how it interacts with the same annual exclusion math used above.
This is general tax information, not individualized tax or legal advice. The dollar thresholds and modification rules above change over time and your situation may have details that change the analysis, so confirm the current-month AFR and your specific numbers with a CPA before signing anything, especially on larger balances.
Set the rate right the first time
If you're structuring a brand-new loan rather than fixing an existing one, you can sidestep this entire problem by choosing the loan type deliberately. Our guide to what interest rate to charge on a family loan walks through the tradeoffs between locking a term rate and letting a demand loan float, and our broader 2026 guide to family loans and taxes covers the AFR and gift tax rules this article builds on.
Whichever path you take, document it. Generate a clean family loan agreement for the new terms, or start tracking the loan so the interest, balance, and payment history stay straight no matter how many times the rate changes over the life of the loan.
