This guide will cover dos that enhance the harmony within a family, and there are don'ts that are catastrophic for a family loan.
Family loans come with much-needed economic strength when one decides to have them and can offer various sources to lend to. The trouble is that mixing cash and family members is often a sure constituency of tension and misunderstanding. Whether you're the borrower or the lender, you have to take some care around family loans.
The Allure of Family Loans
After all, family loans are oftentimes seen as a much easier, more elastic way of getting around a loan from a bank or credit union. The benefits they boast have swayed many to:
Lower Interest Rates: Sometimes, family loans have low or no interest; hence, they are cheaper to borrow from.
Flexible Repayment Terms: Family members may offer softer repayment terms such as giving more time or much flexible schedules for repayment.
Credit Checks Aren't Usually a Problem: For the most part, lending between family members doesn't require all of the formalities and credit checks that are involved in an active loan agreement; this can actually turn out to be a good thing for those with less-than-ideal credit.
These may render family loans appealing, yet there are also a couple of potential pitfalls to be considered. In even the closest of families, money can induce friction into a relationship. For all dynamics in such a situation to come out unscathed, only the openness of communication and respect by all parties involved can suffice.
Lower Interest Rates: Sometimes, family loans have low or no interest; hence, they are cheaper to borrow from.
Flexible Repayment Terms: Family members may offer softer repayment terms such as giving more time or much flexible schedules for repayment.
Credit Checks Aren't Usually a Problem: For the most part, lending between family members doesn't require all of the formalities and credit checks that are involved in an active loan agreement; this can actually turn out to be a good thing for those with less-than-ideal credit.
These may render family loans appealing, yet there are also a couple of potential pitfalls to be considered. In even the closest of families, money can induce friction into a relationship. For all dynamics in such a situation to come out unscathed, only the openness of communication and respect by all parties involved can suffice.
The Do's of Family Loans
- Do Have a Written Agreement
Whenever giving or receiving a family loan, it should always be in writing. With all the feelings and mutual trust you may have with the other party, getting your terms down on paper helps avoid misunderstandings later on. The written agreement shall contain the following information:
- Loan Amount: The amount to be lent.
- Interest Rate: Agreement to include whether loan accrues no interest or what percentum rate of interest accrues.
- Payment Structure: Spell the terms of payment. Clearly state when the payments are due, how much is to be emulated, and life of the loan.
- Default of Payment Consequences: Make it known, in clear terms, what action will be taken in case the borrower strays from paying.
- Writing everything down is important because in this way, both parties agree on the document and can refer to it at any time a disagreement arises.
- Do Consider the Tax Implication
Quite often, if a huge amount is being loaned then the owner needs to consider the implications of taxes. Also, a minimum amount of interest must be charged by the IRS in loans exceeding a total amount, a rate for which is known as the Applicable Federal Rate. If interest is not charged, or is below the federal AFR, the IRS can then classify the loan as a gift and then it will have the potential to be tax liable.
- For instance, if you lend more than this year's annual gift tax exclusion in 2023, $17,000, years into the future without interest, the IRS may consider that a gift, and you'll be required to pay a gift tax. To avoid this, ensure that your loan agreement meets the requirements stipulated by the IRS.
- Do Treat It Like a Business Transaction
Of course, this might be a bit enticing; it is highly relevant to start treating the family loan with the seriousness that you would give any other financial transaction. This may be done by:
- Documenting everything: Record the times, dates, and amounts for the different payments either way.
- Being communicative:Talk about your expectations and which changes in circumstances can affect the loan.
- Be Professional:Avail this loan transaction to the highest level of professionalism from very commencement to finally close it once all parties have signed agreements.
This way, you decrease the chances of being misunderstood, and at the same time, you keep your family relation and emotional feelings up.
- Consider impact of your relationship
Before entering into a family loan, first consider what this could do to your relationship. Money is, of course, one of the sensitive issues. If things do not work out as they should, tension between the parties concerned may result in resentment or, worse, estrangement of family members.
- Consider the following
How do you feel should it not be returned? On the other hand, if you are the lender, put yourself in his shoes and think about how it would make him feel should the debtor fail to return the loan.
- How does the other party feel about this loan? If you are the one borrowing money, consider how the lender may feel should you be late with your payment or if you need an extension to pay your debt.
- How is this loan going to change the dynamics? Is the loan going to throw your relationship off balance, where one party feels indebted to the other?
- Discuss openly these possible problems with the other party before you begin the loan.
- Do seek legal advice if necessary
If the amount being lent isn't trivial and or you are not sure what the tax implication may be, then it will be best to seek a lawyer for advice. Legalities can help draw an agreement within the state and federal standards that will protect both parties involved in the loan.
The Don'ts of Family Loans
- Do not Lend More Than You Can Afford to Lose
One cardinal rule of lending money to family is never to lend more than one can afford just to lose. You may be fairly confident that your family member will pay you back; but there's usually a chance they won't. If they can't, then this loan could be an issue for both your finances and relationship.
- Before Lending Money, Consider:
- Your financial situation: Can you afford to lose this amount in case of default?
- Your future needs: Will lending the money interfere with your meeting any of your financial goals, say retirement or education of children?
- Borrower's financial situation: Does he/she have the capacity to pay off the loan or is he already under stress?
Sometimes, when you can't afford to lose the money, it's better to sometimes offer other kinds of support, like helping the borrower think about alternative sources of finance.
- Do not be afraid to say no
It may be hard to say no when a family member requests for money, but you have to put yourself first with regard to your money. If you do not want to loan money or cannot afford to give any away, then say no.
- Refusal to give a loan but, while doing so, still show empathy:
for example, "I value you so much, and I'd like to be in a position to help, but I am just not in that position at the moment to lend money". Suggest other ways you could help-for instance, doing a budget together with him or finding a financial advisor, showing him other means where he would borrow from.
- Never Expect Verbal Agreements
While verbal agreements might be alright for a couple of instances, they are not for a family loan. To begin with, it really does make the enforcement of the terms of the loan difficult. Disputes are not easy to handle without a written contract of the said agreement. Memories fade, giving way to misunderstandings, which can then create minor disputes on the terms of the agreement.
To avoid all these problems, it is always advisable to put everything in writing, no matter how small the amount of loan or how informal the terms of repayment. The written agreement acts as a reference for both parties and may well reduce the chance of dispute later on.
To avoid all these problems, it is always advisable to put everything in writing, no matter how small the amount of loan or how informal the terms of repayment. The written agreement acts as a reference for both parties and may well reduce the chance of dispute later on.
- Don't Let the Loan Go Unmentioned
But this is how it is: some family loans never get mentioned from the day it was agreed just to be good about it, not feeling any unease about money talk. But this is finding its place, though, as one of the main causes for misunderstandings and resentment, especially in case the borrower is delayed in payments.
Instead of letting the loan go into silent mode, bring regularity in discussing the loan. It could be a monthly or quarterly review of the amount paid, problems faced, or adjustment, if any. This keeps you in touch with each other and doesn't allow small issues to blow out of proportion.
Instead of letting the loan go into silent mode, bring regularity in discussing the loan. It could be a monthly or quarterly review of the amount paid, problems faced, or adjustment, if any. This keeps you in touch with each other and doesn't allow small issues to blow out of proportion.
- Do Not Pressure the Borrower
That being the lender, you should not add pressure to the borrowers in urging them to pay back the amount. As much as it is needed, it is already hurting the other party, and in case of this kind of situation, a struggle to the relationship will take place and even more than that, it might hinder the payment.
Alternative to Family Loans
Alternative means available to you, in case one is wary of lending or borrowing money with a family member, it keeps the relationship intact while availing you with the needed solution to your financial needs.
- Co-signing a Loan
Co-sign a loan if your family member needs money, yet having it as a loan does not sit well with you. By cosigning a loan, you accept you will be responsible for the loan if the borrower defaults. Again, it is still a risk, but possibly less than directly lending money to him/her.
- Giving a Gift Rather than Lending
Sometimes giving the gift of money may be even better than a loan. In such a case, if the need is in small monetary amounts and you can spare the financial ability, making a gift might come in handy so that the borrower should not be under any kind of compulsion for return. Just be sure you document the gift to keep things clear.
- Budget and Financial Planning Assistance
You can probably help him make a budget or a financial plan instead of just giving him money. And it might be possible that with your advice and support, he can recover from his financial woes himself without making dents in your own financial health.
- Another Financing Option
If your loved one needs an amount significant enough, help them seek other avenues of money: a bank or credit union personal loan, their home equity loan, or even a peer-to-peer lending service. These alternatives might be more than happy to give your loved one the funds they need without necessitating that your relationship be placed in jeopardy.
Conclusion
Needless to say, family loans can be a real lifesaver when needed, but they come with some risks. The following list of some dos and don'ts, when put into practice, will hopefully make your family loan experience a positive one for both the lender and the borrower. Transparency, clarity in communication, and respect for each other go a long way in making this situation easy between the two parties.
