Family Loans: How to Borrow?Uncategorized
Lending money to a family member (or borrowing from one) might seem like a good idea: the lender gets easy approval and the interest paid stays with the family instead of going to the bank.
In many cases, family loans are successful – but success requires a lot of open conversation and planning. You have to deal with the administrative issues and the (possibly more complex) emotional side of things.
You will also need to manage legal pitfalls such as local tenancy laws and debt collection practices, but most family lenders are not easy sharks, so these issues are less common.
What is a Family Loan?
A family loan is any loan between family members. It doesn’t matter what the money is for. It is just a loan that does not benefit a bank, credit union or online lender that is outside the family.
These loans need to end in a win / win situation – a good deal for the borrower and lender – to keep your family intact. Lenders especially need to understand the risks involved, their motivation for lending, and alternatives to lending.
Generally, lenders want to help someone they love – and it’s a good start.
However, there are several other ways to help, including simply giving money and taking out a loan.
Gifting: If you give money to your family member without expecting it to pay off, things are much simpler. However, you may really need that money someday, and you may want a family member to be responsible for your expenses.
Some people suggest that you never lend to your family unless you are (even secretly) fine, and they are never repaid.
Imitation: You can also swap out the 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 make up your mind, and you may not want to take the risk.
Before deciding if you want to move forward, discuss the loan in detail. If either the borrower or the lender is married (or in a lifetime relationship), both partners must be involved in the discussion. In addition to the lender and the lender, think of anyone who depends on the lender – children or other relatives under the care of the lender, for example.
There is no such thing as being too detailed in these conversations. It’s easy to assume that others see the world the same way you do, and that’s not always true – especially when it comes to money. It’s better to have a few awkward discussions than to have an awkward rest for the rest of your life.
- Do you expect to be repaid? Clean it up.
- Why are you borrowing 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 to pay (monthly, by check, for example)?
- Will you report payments to credit bureaus (this is easiest if you use a third party to assist with loan servicing)?
- What if the lender is injured or disabled?
- Will this credit result in others (such as siblings) inheriting less? Will this be taken into account at the time of your death?
- Do you have a plan (and enough income) to pay back?
- What do you expect to happen if you can’t make a payment in a month (or three)?
- Will the lender know how they spend their money?
- Does the lender have the right to “suggest” how you prioritize costs, choose a career, and spend your time (especially if you don’t pay)?
- How will the lender be financially affected if you are unable to repay (for example, because of your accidental death)?
- Do you need to build a loan and are payments reported to credit bureaus?
Protect the Lender (and Dependents)
The lender may get out of the family loan (earning more than the bank will pay, for example), but lenders take the risk. Remember that nothing is safer than keeping your money in an secured bank account or a federally insured credit union. Moreover, your money is quickly available if you ever need to withdraw from a bank – this is not the case with money you invested in a family member.
You may be sure your cousin will pay, but what if you don’t? Even the most likely person can get into a car accident.
Security: For maximum protection, insist on using collateral to secure the loan. This means you get ownership of a property (such as a house or car) and sell it to get your money back in the worst case scenario. Especially if you make a big home purchase loan, take the right home to protect yourself.
Talk to your local attorney to discuss your risks and all your options for protecting yourself. If not, you won’t know what you don’t know about your exposure.
Use a written agreement to keep everyone on the same page, and to ensure that the lender does not go blank. Local lawyers and online services can provide the documents – make sure they are legal in your country.
The IRS is involved in everything – even the loans you make to family members. Be sure to check with your local tax advisor before signing a contract or making a loan.
Loans are allowed to charge a relatively low interest rate. However, if little is charged, the IRS views any interest that should be paid as a “gift” and you will need to be aware of the gift tax. Look for applicable federal rates and speak with your tax advisor before settling the rate.
You may also need to have certain conditions in writing (and possibly secured by a delay) to satisfy other IRS requirements such as interest deduction.
These are just two things to consider – your tax advisor can tell you more.
Credit management is complicated. If you need help, there are several online services that can make the process easier. They will:
- Handle payment logistics, setting up automatic transfers between bank accounts
- Report the activity to credit bureaus
- Provide documents tailored to your situation and your country
- Provide tax documents (if applicable)
Examine each provider and ask what services they can and cannot offer before signing a contract. You can also work with local attorneys and businesses that offer the same services.