How to Handle Lending and Borrowing Money With Family
Follow this advice when mixing finances and family
Lending money to a family member—or borrowing from one—might sound like a good idea: The borrower gets easy approval, and any interest stays in the family instead of going to a bank.
In many cases, family loans are successful—but success requires a lot of open conversation and planning. You need to handle the administrative matters and the (possibly more complicated) emotional side of things. You’ll also need to navigate the potential financial and legal pitfalls.
Basics of Family Loans
A family loan, sometimes known as an intra-family loan, is any loan between family members. It can be used by one family member to lend money to or borrow it from another or as a means of wealth transfer—the purpose doesn’t matter. It’s just a loan that does not use a bank, a credit union, or another traditional lender that’s outside of the family.
A family loan is distinct from a gift, which the IRS defines as the transfer of property or money to someone else without expecting to get something of equal value in return. Market interest rates generally have to be applied to what you lend or borrow for your family loan to be treated as a loan; if you make an interest-free or a reduced-interest loan that is below the market interest rate, you are making a gift in the eyes of Uncle Sam.
Whether you are lending money to or borrowing money from family, the loan generally needs to be mutually beneficial for both the borrower and the lender to keep your family intact. Lenders, in particular, need to understand the alternatives, risks, and tax implications of a family loan.
Alternatives to Family Loans
Generally, lenders want to help someone they love—and that’s a good start. But there are two main ways to financially help a relative besides lending money to them.
- Gifting: If you give the money to your family member without the expectation of getting something of equal value in return, you are giving a gift, which may put a smaller financial strain on the relationship. However, it's worth considering whether you might actually need that money someday, in which case a family loan may be preferable because you might want the relative to be responsible for their own expenses.
- Co-signing: You could also co-sign a loan that your family member takes out to help them get approved. Your income and credit might be sufficient to help them get the loan. When you co-sign, however, you guarantee that your relative will repay the debt on-time and in-full. In other words, you take responsibility for the debt if your relative doesn't pay the loan. Your credit is, therefore, at risk when you co-sign, and you might not be willing to take that risk.
Benefits and Risks of Family Loans
A family loan can often result in a win/win situation for both parties, but the arrangement is not without risk.
Lower interest rates
Mutually beneficial loan terms
Lack of funds availability
- Lower interest rates: The borrower can potentially get a much lower interest rate on the loan than a traditional lender would offer.
- Mutually beneficial loan terms: The lender and the borrower can agree to a shorter or longer loan term than a traditional bank loan affords or interest-only payments at the beginning of the loan term.
- Forbearance: The lender's relationship with the borrower may make them more willing to pause or reduce payments on the family loan when the borrower experiences a financial emergency.
- Non-payment: You might be confident that your relative will eventually give you your money back, but even the most dependable person can fall on hard times and fail to repay you. While traditional lenders take substantial measures to prevent the default of loans, family loans focus on providing money to the borrower, and, without proper planning, offer little to no safeguards against the risk of default.
- Damaged relationship: If the lending or borrowing arrangement takes a turn for the worst, the relationship between you and your family member could sour forever.
- Lack of funds availability: Money that you deposit in a bank is readily available if you ever need to withdraw from the bank—that’s not the case with money you’ve invested in a family member.
Preserving the Family Relationship
Before you decide whether to move forward with lending money to or borrowing it from family, discuss the loan in detail. If either the borrower or lender is married (or in a lifelong relationship), both partners need to be involved in the discussion. In addition to the borrower and lender, think about anyone who is dependent on the lender—children or other relatives under the lender’s care, for example.
There’s no such thing as being too detailed in these discussions. It’s easy to assume that others view finances the same way you do, and that’s not always true. It’s better to have a few difficult discussions now than to risk permanently damaging the relationship.
Protecting the Lender (and Dependents)
A lender might come out ahead with a family loan, but lenders should take certain precautions to minimize the substantial risks that they take when extending a loan to a relative.
- Speak with a local attorney. Engage the services of an attorney to discuss your risks and any options to protect yourself. If you don’t, you won’t know what you don’t know about your exposure.
- Encourage the borrower to safely deposit the funds. You don't want to risk the borrower losing the loan and requesting it again because of careless habits. Advise the borrower that until they need to use the proceeds from the loan, nothing is safer than keeping the funds in an FDIC-insured bank account or federally insured credit union.
- Get it in writing. Use a written loan agreement to keep everybody on the same page and to help ensure that the lender doesn’t walk away empty-handed. Local attorneys and online services can provide template documents that you can complete to get a head start.
- Use collateral. For the greatest protection, insist on using collateral to secure the loan. This means that you get to take possession of an asset of value and sell it to recover your money in a worst-case-scenario. If you make a large family loan for a home purchase, you may want to get a lien on the home to secure the loan and protect yourself against loan default.
In the event of a default, a written agreement can help prove to courts that you had the expectation of being repaid and the intent to enforce the repayment of the debt.
Understanding Tax Laws
The IRS is involved with everything—even loans you make to family members. Check with a local tax advisor before signing agreements or making a loan.
Lenders are allowed to charge a relatively low-interest rate. However, if you don't charge interest or charge below the market interest rate, the IRS may view your loan as a “gift,” and you, as the lender, could be on the hook for gift taxes. To keep your family loan from being characterized as a below-market loan, you'll generally need to charge the Applicable Federal Rate (AFR). Speak with your tax adviser before settling on a rate.
In addition to federal law, you'll need to comply with state laws, such as those governing usury. The interest rate you charge must not be considered exorbitant under state law.
Those are just a few things to consider—your tax adviser can tell you more.
Given recently low APRs and the fact that most family members aren't loan sharks, usury is unlikely with family loans.
Putting the Family Loan Into Writing
The written loan agreement should set the terms for the lender and the borrower. When preparing it, ensure that the document addresses the following concerns and that both parties sign it to make it legally enforceable.
Terms for Lenders
If you are extending a loan, factor in the following when drafting the loan agreement:
- How much you plan to lend
- Why you are lending the money
- Whether you expect to get repaid
- How and when you expect payments to be made (monthly and by check, for example)
- What interest rate applies to the loan
- What you will do if the borrower stops making payments (charging late fees or taking collateral, for example)
- Whether you will use a third-party loan servicer and whether it will report payments to credit bureaus
- What you will do if the borrower becomes injured or disabled
- If the loan will result in others (such as the borrower’s siblings) inheriting less and whether that will be taken into consideration upon your death
Terms for Borrowers
The person receiving the family loan should consider the following aspects of the loan:
- Whether you have a plan (and sufficient income) to repay the loan
- What you plan to do if you can’t make payments for one month (or a few months)
- Whether you plan to communicate to the lender how you will spend the loan proceeds
- Whether the lender has the right to “suggest” how you prioritize expenses, choose a career, and spend your time (especially if you’re not making payments)
- How the lender will be affected financially if you’re unable to repay (because of an accident, for example)
- Whether you agree to build credit and have the payments reported to credit bureaus
Using Family Loan Services
If you need help with the process, several online services can reduce potential frustrations. They will:
- Handle the logistics of payments, setting up automatic transfers between bank accounts
- Provide documents tailored to your situation and your state
- Provide tax documents (if applicable)
Research each provider and ask what services they can and can’t offer before you sign an agreement. You can also work with local attorneys and businesses that offer similar services.