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Family Loans: How to Approach Lending Money to Family
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Lending money to a family member can be fraught with complications and unintended consequences. A family loan doesn’t come with the same requirements as a traditional loan, but that doesn’t mean it’s the best option for everyone.
A February 2020 survey from LendingTree found that, among people who lent money to family or friends, about a third of these borrowers and lenders reported negative consequences, including hurt feelings and resentment. Plus, more than a third of lenders said they hadn’t been paid back.
Here’s what you should know about family loans before borrowing or lending money.
What is a family loan?
A family loan is a term for when you lend money to someone you’re related to. There is an expectation that it will be paid back, so it isn’t the same as a gift, but it is an informal agreement as compared to a traditional loan. They don’t necessarily require the borrower to pay interest, either, though that’s up to the parties involved.
A major plus to family loans is that they can be a way to help your family members avoid taking on high-interest debt, and even access funds when they may otherwise be unable to, such as with a personal loan. But family loans can put the lender in an uncomfortable position if the borrower fails to repay the debt or falls behind on payments, especially if the lender was counting on that money.
How to approach lending money to family
1. Create a loan agreement form
A family loan likely won’t be as formal as a loan you’d apply for with a traditional lender. However, that doesn’t mean you shouldn’t get the terms laid out in a loan agreement form or loan contract. Doing so ensures that both parties understand what’s expected of each other, so it should be a required step in the process. At the very least, it should contain:
- Borrowing amount
- If interest will be charged (and if so, how much)
- What the payments will be and how often
- How long the borrower has to repay the loan
- Late fees, if any
- When payments begin
Both parties should sign the loan agreement, and each should have a copy of the document for future reference. That way, nothing is left to the imagination, and there’s less chance of a misunderstanding down the road. You may wish to consult an attorney for an added measure of security.
2. Decide whether to charge interest
To decide if interest should be charged, it’s important to understand the tax implications. For example, if you skip interest charges or charge below the applicable federal rate (AFR), the IRS sees the money as a gift and there would be imputed interest charges if the gift or gift loan is over $10,000 — this would effectively add to your taxable income. So for a smaller loan, it could make sense not to charge interest if both parties agree.
If you do decide to charge interest, on the other hand, you would have to abide by federal guidelines when it comes to the rate in order to avoid the gift, or gift-loan, status by the IRS’s standards. For reference, the AFR — which represents the minimum interest rate for a family loan in order to avoid imputed interest charges — is set at 0.91% to 1.43% for short- to long-term loans compounded semiannually, as of April 2020.
Tax implications of family loans
If you don’t charge interest on a family loan, or charge below the AFR, the family loan could be subject to the gift tax, which is typically paid by the donor, unless it’s less than $15,000. However, even if the gift is over that amount, the tax is really only paid by those who donate an extremely large amount in their lifetime (over $11 million.)
The real expense for no- or low-interest family loans would come in the form of imputed interest charges for gifts or gift loans over $10,000. Because those raise your taxable income, you would have to pay additional taxes to the IRS, even though you aren’t actually collecting interest, or as much interest as expected. So for those larger loans, it could become burdensome for the lender.
Since family loans are informal, you would also be on the hook for maintaining the records for the IRS. That’s why it’s a good idea to speak with a tax advisor if you’re uncertain about what’s expected of you as a family loan lender, and how to stay on the right side of the IRS. You’ll also need to comply with your state’s usury laws, which may place limits on the interest rate you can charge for this type of loan.
3. Have a plan in place to ensure repayment
One of the best ways to prevent familial strife from bubbling up as a result of a family loan is to maximize the chance for full repayment. For example, you both should know what happens if the borrower loses their job or suffers another kind of financial hardship and can’t make payments. You may agree ahead of time to pause payments for a time in this kind of case.
Just as importantly, the borrower should provide proof that they can make payments on the debt. They could share income information or agree to put down collateral for the loan. Should they fail to repay, the lender could have the collateral.
4. Keep clear records
Like the loan agreement form, maintaining records is a vital step to ensure that everyone is on the same page and can thereby help prevent negative feelings from developing. Keeping track of payments, for example, can prevent confusion around where the borrower is in the repayment process.
One way to easily keep records of payments is to use a payment system, like Venmo or bank-to-bank transfers. That way, there’s an automatic paper trail and proof of payment that can be accessed by both parties. Once the last payment has been paid out, a paid-in-full letter is another excellent record to officially bring the loan repayment question to an end. You can find many free loan paid-in-full letter templates you can use online.
Pros and cons of family loans
Provides access to funds regardless of credit. With a family loan, you may not be required to have excellent, or any, credit to get the cash you need. In fact, there is no application process at all unless you want one.
May be a source of interest-free loans. Unlike a traditional loan, borrowers may not have to pay interest on the funds they receive, which is extremely helpful if you’re in real need of funds but don’t want to be trapped in debt.
Allows family members to help each other. A family loan can enable the lender to feel like they’re making a valuable contribution and supporting the borrower.
Negotiation is part of the process. Traditional loans typically involve a lender dictating the terms, and the borrower can agree or go elsewhere. But with a family loan, negotiation is built into the lending process, and that means the borrower can ask for what they feel they need.
If there’s interest, it can be well-below what may otherwise be offered. If the lender and borrower agree to an interest rate equal to the AFR, that is still more affordable than what you’d get from a traditional loan.
Can lead to damaged relationships. When the terms and requirements aren’t laid out clearly as they would be in a traditional loan, there’s the opportunity for miscommunication. A missing payment could result in strife in familial relationships.
May put family members in harm’s way financially. The lender’s circumstances may change after funding, and losing a significant amount of money can prove a barrier and cause them to take on debt. And if the borrower skipped a payment, that might further endanger the lender’s finances.
Gifts and gift-loans may prove expensive come tax time. If you choose not to charge interest, or charge below the AFR, you may be subject to imputed interest charges as well as a gift tax.
If too little interest (or none) is charged, and the loan is more than $15,000, it would have to be disclosed to the IRS. For larger loans, there may be a gift tax associated, which would be charged to the person who lent the money to the borrower.
Can lead to errors. Since family loans don’t come with the same structures as traditional loans, there’s more opportunity for errors, like poor record keeping and unclear requirements.
Alternatives to family loans
Give a gift
In contrast to a family loan, a gift would be given to the recipient without the expectation of repayment. For those who can afford to give, this can be a substantial aid to those who require financial assistance, particularly if they aren’t in a position to repay any kind of loan, even a family loan with no or low interest.
However, in order for this to make sense, it must be an affordable loss for the gifter — in other words, make sure that the loss wouldn’t cause you to get into debt or otherwise financially suffer.
You should also keep in mind that gifts are subject to the IRS gift rules — this means it cannot exceed $15,000 for a given individual as of 2020 (or $30,000 if given by an individual and their spouse), otherwise it may be subject to the gift tax, which ranges up to 40%. That said, the tax only actually kicks in after the donor exceeds $11.4 million in lifetime taxable gifts, as of 2019.
Cosign a loan
For borrowers who may not be able to qualify for a traditional loan on their own, using a cosigner can be one way around those credit limitations. However, it’s important to keep in mind that, as a cosigner, you’d be putting your own finances on the line. Many lenders require the cosigner to take over payments if the borrower is unable to make their payments. And if the borrower defaults, that would impact your credit, too.
So, this is only a good option if the borrower has a stable income and understands the implications of having a cosigner.