Four Tips for Loaning Money to Family
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At some point in your life, you may have considered loaning money to a family member who has fallen on tough times. If you are financially able and take the proper precautions, this can be a great way to soften the blow and help a loved one in need. But remember: Just like in an airplane, you need to make sure your own “mask” is on before trying to help others.
A loan between family members has its pros and cons. On the one hand, if you're the one in need of money, a family member likely isn't going to check your credit scores or dock your scores if you aren't completely on time with repayment. On the other hand, if you fail to pay the money back on time or – even worse – default on a family loan, it could seriously impair your relationship with the lending family member and cause severe damage to their finances.
The terms of the loan should be documented and countersigned by all parties. It is recommended that you also have a third-party witness, such as a CPA or financial planner, sign the documents. The documentation needs to include all terms (interest rate, payment schedule, term of loan, etc.) and should clearly state recourse if things go sour. For example, can the lender call the loan early and, if so, under what conditions? What if the borrower can't make payments? Are there any penalties? If so, what are they? All parties should try to imagine every possible scenario—good, bad and ugly—and discuss and document how they would be handled.
While this may seem excessively formal, it's important to treat any loan agreement between family members as an arms-length business transaction to protect both parties involved.
Here are some more tips to consider for arranging a loan with a family member:
1. Commit the terms to writing with a promissory note or informal contract.
Both parties should sign this note, and it should contain the following information:
- Loan amount
- Repayment schedule
- Rate of interest
- Consequences if the loan isn't paid back on time
A promissory note may protect both parties in any number of circumstances and may prevent a he-said-she-said situation.
2. Charge a reasonable rate of interest on the loan.
An interest-free loan is likely to be considered a gift rather than a loan and could require the lender to file a federal gift tax return. If the interest rate is below the applicable APR (set by the IRS), the lender might have to declare imputed interest as income. Basically, in this situation, the IRS may take the difference between the applicable APR and the charged interest rate and use it to determine the interest that should have been paid by the borrower. The IRS treats this extra amount as income to the lender. Therefore, taxes will be due, even though the lender has not received any cash payment for this extra interest.
3. Protect yourself in the case of a death with proper documentation.
If your loan is undocumented and one party dies before the loan is repaid, you may find yourself in the middle of an unwanted dispute. For example, if the borrower dies before the loan is fully repaid, the lender might come after the recipient's heirs. If the terms of the loan aren't documented, the borrower's heirs can deny that such an arrangement existed, and the lending party would be out their money. On the flip side, if the lender dies before repayment, the borrower might claim that the lender had agreed to forgive the rest of the loan in the event of their death. Again, without proper documentation, it would be hard for either side to prove what was mutually agreed.
4. Never lend money to a family member that you need yourself.
We all want to help a family member in financial need, but don't do it if lending the money would jeopardize your own financial security – especially during a pandemic or other time of fiscal uncertainty.
If you are contemplating asking a family member for a loan or making such a loan, take the process seriously. Even when trusted family members are involved, treat loaning money as a business transaction and, if needed, consult with a financial or legal adviser who is well-versed in this area.