Money Legally: Have you ever had a friend or family member ask for a loan? You’re not alone. Many people turn to trusted friends and relatives for help paying off debts, starting their own business, or paying off a home or car loan.
Family loans, often called intra-family loans, and loans to friends can be successful, but they require clear communication about the terms and risks and requirements.
This article will provide you with the information you need to know to get through the process with your funds and your relationships intact.
Lend money to a friend or family or not?
If you have concerns about lending your hard-earned money to someone else—even someone you know well—you have good reasons.
According to a Bankrate survey of nearly 2,500 U.S. adults in 2019, 60 percent have lent cash to a friend or relative, 21 percent have co-signed for a loan or rental, 17 percent have lent their credit card. However, 35 percent of these lenders reported that they lost their money, harmed their credit score, or experienced a bad relationship because of the debt.
How can you lend your money the right way?
Your first step should be to answer the following questions honestly. The first five questions relate to your finances, and the rest relate to your emotions.
- Will you still have enough money in reserve for emergencies after taking out the loan?
- Will the loan affect achieving your financial goals?
- Do you have any consumer debt (such as credit card balances)?
- Will a delay in loan payments affect your monthly budget?
- If the loan is never repaid, how much will that loss affect your financial situation?
- If the borrower never pays the loan back, will the relationship end?
- If the borrower misses payments, will the relationship be harmed?
- If the borrower spends the money on luxuries (such as travel) before paying you back in full, how will you handle it?
Your answers to these questions will help you decide if you are in a position to lend money to a friend or family member. While rejecting a loan request can lead to hurt feelings, such reactions can also help you explain your decision.
Is it legal to lend money to a friend?
Is it legal to lend money to a family member, friend or acquaintance? In short, any such loan carries the same legal responsibilities as a loan given by a bank. Repaying the loan becomes a legal obligation for the borrower, and the lender can take legal action against the person who does not repay the loan in small claims court.
To ensure that there are no misunderstandings about the loan and its repayment, you should put all the details in a written document that everyone reads and signs.
Although it may seem formal for close friends and relatives to sign the agreement, it will help minimize any conflicts or misunderstandings that may arise in the future.
Pros and Cons of Family Loans
Here are the primary benefits and risks of family loans.
Pros
Simple approval. Traditional lenders usually have a formal loan application process that involves credit checks, verification of income, and documents such as tax forms, W-2s, and pay stubs. Family loans can avoid this lengthy process.
Lower interest rates. The lender is entitled to charge an interest rate on the loan, but they may offer a lower rate than what a traditional lender would offer on a similar loan. Borrowers also will not have to pay the upfront origination fee that some lenders charge.
Advantageous terms. The lender and borrower can agree on a loan time-frame that is more advantageous than what is offered by a traditional lender.
Hardship option. In a friend or family loan the lender is usually willing to pause or reduce payments if the borrower faces a financial hardship such as job loss or illness.
Cons
Non-payment. Even someone you consider trustworthy and reliable can default on the loan.
Loss of money. You will not have the use of the money you have lent to a family member. This situation can be problematic if you experience financial difficulty yourself.
No credit boost. Since family loan payments are not reported to the credit bureaus, successful loan repayment will not help the borrower’s credit rating as traditional loan repayment does.
Possibility of conflict or damaged relationship. If payments are missed or not made at all, your relationship with the borrower can become strained or even broken. Sometimes the resulting stress can even affect your relationship with your connected friends and family members.
Alternatives to Family Loans
While you’re considering these advantages and disadvantages, you may be wondering if there are any alternatives to raising family loans. The two main options are gift giving and co-signing a loan.
Gift giving. One way to alleviate the question of “will they” or “will they not” whether or not someone will repay you money is to give money as a gift.
Before giving a financial gift in exchange for a loan, it’s wise to make sure you’ll be financially secure without that money.
Co-signing. Another option is to co-sign your friend or family member’s loan application with a financial institution. Your income and good credit rating can help them secure a loan.
The downside to this arrangement is that failure to repay a co-signed loan can harm the credit scores of both the borrower and the co-signer, and the co-signer is responsible for the loan if the borrower doesn’t pay.
Tax Laws for Family Loans
Any loan is a legal contract, and as such, it has potential tax consequences for the borrower as well as the lender. Borrowers must repay the loan as agreed or claim the canceled debt as income.
Lenders who charge interest on a loan must pay taxes on any interest earned from the borrower. You can avoid tax complications as long as you charge an interest rate at least equal to the applicable federal rate (AFR).
If you don’t charge interest, the IRS requires you to pay taxes on what’s called an “imputed interest fee.” Imputed interest is the amount of interest the IRS believes the lender should have charged for the loan. As long as the total amount is less than the gift-tax exclusion amount for that calendar year, the unrecovered interest can be applied as a tax-free gift.
It’s a good idea to check with your tax advisor before making any kind of loan to a friend or relative.
Write a family loan agreement to protect yourself
Creating a written loan agreement helps reduce your risk when lending money to a friend or relative.
The simplest loan agreements between family and friends are often called an “IOU.” These casual agreements usually involve small sums of money and just mention the amount that needs to be repaid. They do not include any interest provisions and may not even state when payment is due.
Another type of family loan document is the promissory note. The promissory note usually includes the interest rate and repayment terms.
Typically, IOUs and promissory notes are signed by the borrower, although they can also be signed by the lender.
The loan agreement is a document that includes all the details of the loan and is signed by both parties.
You can find a variety of free loan agreement template’s on online. Here are the basic elements that should be included in a family loan agreement:
The date of the loan, the amount, and how it will be used?
The repayment terms, including the required payment amount, their frequency, and the date when the loan will be paid in full.
The interest rate. The IRS sets an AFR each month. If the loan can be repaid early without a penalty, include how much interest will be saved by paying it off early.
What happens if the borrower temporarily misses payments or stops making payments altogether.
Many people have lost income and faced other financial difficulties due to the COVID-19 pandemic. If you have the financial means, lending a loan can be a satisfying way to help a friend or family member get back on their feet. By putting the terms of the loan in writing and maintaining clear communication, you can help without hurting your own back account or ruining your relationship.
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