Family Loans: How to Borrow and Lend with 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 paid 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.
To do it right, focus on three key areas:
- Protecting your relationships
- Protecting the lender (including any dependents or heirs) financially
- Staying out of trouble with the IRS
You’ll also need to navigate legal pitfalls like local usury laws and abusive debt collection practices, but most family lenders are not loan sharks, so those issues are less common.
What is a family loan?
These loans need to end up in a win/win situation – a good deal for both the borrower and the lender – in order to keep your family intact. Lenders especially need to understand the risks, their motivation for lending, and the alternatives to making a loan.
Generally, lenders want to help somebody they love – and that’s a good start.
But there are several other ways to help, including simply gifting the money and cosigning on a loan.
Gifting: if you give the money to your family member with no expectation of getting repaid, things are much simpler. However, you might actually need that money someday, and you might want your family member to be responsible for his own expenses.
That said, some people suggest that you never lend to family unless you’re (even in secret) okay with never getting repaid.
Cosigning: you could also cosign a loan and help the borrower get approved. Your income and credit might be enough to do the trick. However, your credit is at risk when you cosign, and you might not be willing to take that risk.
Protecting the Relationship
Before you decide whether or not to move forward, 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 anybody 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 see the world the same way you do, and that’s not always true – especially when money is involved. It’s better to have a few awkward discussions now than to have awkward holidays for the rest of your life.
- Do you expect to get repaid? Make that clear.
- Why are you lending the money?
- What will you do if the borrower stops making payments? Will you charge late fees or take collateral?
- How and when do you expect payments to be made (monthly, by check, for example)?
- Will you report payments to credit bureaus (this is easiest if you use a third party to help with loan servicing)?
- What if the borrower is injured or disabled?
- Will this loan result in others (such as the borrower’s siblings) inheriting less? Will that be taken into consideration at the time of your death?
- Do you have a plan (and sufficient income) for repaying the money?
- What do you expect to happen if you can’t make payments one month (or three)?
- Will the lender know how you spend your money?
- Does the lender have the right to “suggest” how you prioritize expenses, choose a career, and spend your time (especially if you’re not making payments)?
- How will the lender be affected financially if you’re unable to repay (due to your accidental death, for example)?
Protect the Lender (and Dependents)
A lender might come out ahead with a family loan (earning more than the bank will pay, for example), but lenders are taking a risk. Remember that nothing is safer than keeping money in an FDIC insured bank account or federally insured credit union. What’s more, your money is available quickly if you ever need to withdraw from the bank – that’s not the case with money you’ve invested in a family member.
You might be confident that your relative will repay, but what if they don’t? Even the most dependable person can get in a car accident.
Collateral: for the greatest protection, insist on using collateral to secure the loan. This means you get to take possession of an asset (such as a house or car) and sell it to recover your money in a worst-case-scenario. Especially if you make a large loan for a home purchase, get a lien on the home to protect yourself.
Speak with a local 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.
Use a written 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 documents – make sure they’re legal in your state.
The IRS is involved with everything – even loans you make to family members. Be sure to 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 charge too little, the IRS views any interest that should have been paid as a “gift,” and you’ll need to be aware of gift taxes. Look for Applicable Federal Rates (AFR) and speak with your tax advisor before settling on a rate.
You might also have to have certain terms in writing (and possibly secured with a lien) to satisfy other IRS requirements such as deductibility of interest.
Those are just two things to consider – your tax advisor can tell you more.
Handling a loan is complicated. If you need help, there are several online services that can make the process easier. They will:
- Handle the logistics of payments, setting up automatic transfers between bank accounts
- Report activity to credit bureaus
- 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 the same services.