What is the best way to lend significant amounts of money to family members and keep your family intact? Many experts say, simply refuse to do it.
That is easier said than done. A 2013 study by ConsumerCredit.com reported that 80% of people would lend money to a family member in hard times, and 67% would lend money to a friend in similar distress. Most of us feel some obligation to help out fellow family members, even if we are not sure we will ever see the money
Here are some tips to keep the family loan from becoming a family wedge.
- Refuse if You Can't Afford It – If you assumed you would never get the money back – and for loans within families, that is a distinct possibility – would it put you in financial distress? If so, you should refuse. To stretch a metaphor, don't jump in to save a drowning person if you have trouble swimming.
- Treat it as a Business Transaction – Because that is exactly what it is. Make sure that you have laid out a plan for repayment by defining the loan term, payment, and interest rate. You may want to make it a no-interest loan, but this could get you in trouble with the IRS (see "Tax Considerations" below).
If you like, you can outline the purpose of the loan. At the very least, you should ask.
You can stretch out payments and cut slack in a ways that a bank cannot, but make sure you understand the consequences.
- Put It in Writing – Of course, if you don't document your business transaction, you needn't have bothered settling on terms in the first place. Templates of promissory notes and agreements are available on several online sites. Some online vendors offer personalized agreements and e-mail reminders, but a simple note signed by both parties should suffice.
- Record all Payments – We suggest making simple payment coupons and issuing receipts just as a bank would do. It doesn't have to be fancy. Have fun designing your coupons if you like, but record the payments all the same.
- Check Tax Considerations – Loans that are never repaid, or no-interest loans that are above the gift tax threshold of $14,000, are considered gifts and not loans. The IRS issues the Applicable Federal Rate (AFR) monthly for people to use with below-market loans. Charge the appropriate interest rate to avoid misclassification as a gift.
Depending on the length of the loan and the compounding, the rates are generally anywhere from 0.2% to 3.5%. The AFR is determined by comparison with appropriate short-, medium- or long-term securities.
Don't forget to report any interest paid as taxable income on your taxes. If you are not sure of the rules or limits, nor what paperwork is required to execute a loan, check the IRS website or contact your local office before you make the loan.
Other things to consider:
Co-signing a loan with your relative through a traditional lender is an option, but it is a dangerous one. Should your relative default, you will be responsible for repayment. Your credit rating could take a hit before you even realize the default occurred.
If your relative has a history of borrowing and not repaying, consider that you may be enabling him or her and not getting to the root of the problem. Sometimes tough love is required.
Most important of all, whatever your plan is, make sure your spouse is on board with it. It’s one thing if your cousin not repaying the loan causes a family rift; it’s another if the tension is between you and your bedmate. Regardless of your income, you can't afford that sort of "loan penalty!"