It’s natural. You love your family members and want to help them out whenever possible. However, when your son, daughter, brother or sister come to you in need of money, how do you draw the line between a loan and a donation? Here are a few easy tips for lending money to family and still keeping your financial and emotional integrity in tact:
Make sure you are financially sound before lending to others
Of course everyone would like to be able to help a child buy their first home or pay off their college education. But, if the reality is that you can’t financially swing it – then don’t. Do your research about what lending may mean for your finances and your credit score and also consider speaking with your financial advisor about making such a move. There is no reason to put your financial security at risk when there are a multitude of other viable financing options out there. (For more information, read Working with a financial planner.)
Draw up a contract
Sure, it sort of takes the intimacy out of it, but drawing up a legal contract is nothing short of a smart idea when lending money. Not only does it provide a sense of security and formality to the agreement, it also helps to organize the process, making it easier for everyone involved. In creating a contract, everything is out on the table, including loan length, loan payments and loan terms and conditions. It’s simply a good foundation to help you and your borrower get the most out of the loan.
Get a competitive interest rate
As a loving family member, you may want to give your kids or siblings a break in their borrowing interest rate. You don’t have to rake them over the coals, but you do have to consider the interest you are losing by not having those funds in your own investments. With this in mind, you should research interest rates to determine what is competitive by market standards, what you feel comfortable with in terms of your relationship and what is going to keep your finances working for you. Also keep in mind that if you charge an interest rate below a certain threshold determined by the Internal Revenue Service (IRS), your loan may be considered a gift and subject to certain taxes. The minimum interest rate required by the federal government is known as the Applicable Federal Rate.
Learn the tax ramifications
When lending money to family members, you are not only doing them a favor, you are also making an investment. That is, you will make money on the funds you loan. Just as the IRS requires that you use a reasonable interest rate, they also require that you declare any money you earn on a loan in your income taxes. Keep in mind that you are entitled to “gift” another individual up to $12,000 annually tax free. (Note that $12,000 is the annual exclusion for 2006 and 2007.) You may want to factor this into your mortgage contract agreement. (To learn more, please see your attorney or accountant or visit www.irs.gov.)
Don’t risk your relationship
When it comes down to it, no investment is worth your relationship. To this end, it is important to seriously discuss this endeavor and its long-term consequences – both good and bad – before entering such an arrangement. If you decide that going forward with the loan is a good idea, remember to keep the communication channels open after the loan contract has been drawn up and signed to avoid any tension or surprises down the road.