Life is full of expensive situations where you might find yourself in need of some extra cash to help you achieve your goals. Enter family loans. Whether you’re starting a business, getting ready to welcome your first child, looking to pay off your student loans, or buying a home, a loan from a family member could be a good option for both of you.
Of course, borrowing from a family member can also be emotionally complicated. After all, you’re unlikely to sit down with your credit card company on Thanksgiving. Familiarizing yourself with common best practices for a family or personal loan (and maybe sharing this article with your family member, too) can help put you both on the same page. Of course, since it’s family, you can’t guarantee that disagreements won’t pop up — but having some guardrails in place may mean the disagreements will continue to center on the usual pumpkin versus pecan pie and not on financial matters.
How a family loan works
A family loan is an agreement between one family member who wants to borrow money and another family member who is willing to loan it. A family loan can be mutually beneficial (and drama free) in a few different ways.
For the borrower:
- You might receive a lower interest rate from a family member than you would from a bank loan.
- Your family member might not care about your credit score
- Your family member might be more flexible with repayment terms than a bank
For the lender:
- You can help out a family member who is in need
- You can agree on repayment and interest terms that are mutually beneficial
- You can charge an interest rate that is better than what you’re earning in your savings account even if it’s still an extremely good deal for the borrower
How to do a family loan
Weird, cool, wonderful, annoying, or even tragic things can happen in the course of a year, and sometimes, it’s easier, faster, and more comfortable reassuring to rely on family members than on anyone else. But even though your family may have incredibly tight bonds and, with an unspoken understanding that all family members have each other’s backs, following some basic borrowing rules can help you avoid misunderstandings. Follow a few guidelines, whether you’re the borrower or the lender. You’ll be glad you did.
Understand interest rates
Figuring out a “fair” interest rate can be tricky. It’s to the borrower’s advantage if the interest rate is set below the average rate from a traditional bank, but not so low that it could be considered a gift. Thankfully, the IRS is here to help out. The IRS sets the Applicable Federal Rates (AFR) which provide a guideline for how much interest should be charged for the loan to be considered a loan and not a gift (a large gift might trigger gift tax for the lender).
If you want to make a zero percent loan, which many families do, you will need to calculate the interest anyway and pay taxes on it if you want to keep your tax house clean.
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Create a contract
A contract will protect you both. You can create a contract using an online service. However, if you’re borrowing or lending a substantial sum of money ($100,000 plus), consider hiring a lawyer to draft a contract that is tailored to your loan. The contract should spell out:
- Loan amount
- Interest rate
- Term length
- What happens if the lender or borrower dies or is disabled
- Whether any collateral secures the loan
Loop in an accountant
Consider talking with your accountant to make sure you’re creating a contract that is fair and that considers all IRS requirements before the contract is signed.
Set up hands-off collection
For a larger loan, consider hiring a loan servicing company. Handling all the details of the loan can be complicated and certainly headache inducing. A loan servicing company can help you manage the loan easily. Make sure you research each company before you hire one and pay special attention to their fees.
For a smaller loan, get an app that will allow you to set up automatic payments. Google Pay can remind you when it’s time to pay or request money.
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Know the rules about gifts
Family loans and gifts might be reportable to the IRS.
If you’re lending money, it’s important to be aware of the gift tax rules. Giving money might not be in your best interest as the lender, because if you give more than $15,000 to any recipient in 2018, your gift would be subject to gift tax by the IRS. Consider talking to your accountant before giving a gift to make sure you’re playing by the rules.
Family and business can be a successful combination
Family loans can be a huge success, and each party involved can walk away as a happy camper. Many of my clients over the years have borrowed money from a relative, and it’s been a fantastic way to provide funds to achieve their money goals.
As long as the borrower and lender can agree to terms, borrowing money from a relative can save you a lot of money in interest charges and can provide flexible terms for a repayment plan that works with your budget.
As the lender, lending money to a relative can be a source of pride knowing that you’re helping your relative get one step closer to financial success. With a few safeguards in place, borrowing money from a relative can be an effective strategy to work toward financial goals.
Shannah Compton Game is a CERTIFIED FINANCIAL PLANNER® professional with an MBA and is the host of the award-winning podcast, Millennial Money, where she shares totally relatable and easy to understand financial advice that will actually make you want to talk about money. Opinions expressed by the author are their own.
Haven Life doesn’t provide tax, legal or investment advice. This discussion is intended as general education only. We encourage you to work with your own personal tax or legal professionals and your financial advisor. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel.
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