When you need some extra money, you might consider borrowing from a family member to. A family loan can help out when you do not want to turn to a bank for help with a short-term cash flow problem. And if you have poor credit or limited income, a family loan can be the only option for accessing credit.
What Should You Know About Family Loans?
With an intra-family loan, the lender is often a parent or grandparent, but recently more adult children have been providing loans to their parents. The interest rates and repayment terms vary and often lack structure. Family loans are quite common in the United States, as studies report 60% of people have received funds that they anticipated paying back from a family member (or close friend).
If you are considering asking a family member for a loan or are thinking about providing funds to a family member, there are numerous potential outcomes.
Alternatives to Family Loans
Before you hand your kid a stack of cash or turn over your credit card to your niece, make sure that both the lender and the borrower are confident a family loan is the best solution. A different arrangement may lead to a better outcome, depending on your exact situation.
Some alternatives to a family loan include:
Gifting
The IRS allows each individual to gift anyone else up to $15,000 per year. Merely giving the money to your family member without the expectation of repayment can avoid future disagreements. Make sure you consult with a tax professional before offering or accepting any monetary gifts.
Personal Loans
Keeping your business loans separate from your personal life can prevent uncomfortable conversations around the holiday dinner table. If the borrower has the credit history to take out a personal loan from a bank, it may be the smart choice.
Co-Signed Loans
The need for an intra-family loan typically arises because the borrower may not have the credit history to access additional funding from the formal banking system. In these situations, co-signing a loan for the borrower may be a better solution than lending the money directly. However, keep in mind that you are liable for the loan’s total amount as a co-signer if the borrower is unable to repay.
Authorized User
If the borrower needs access to smaller amounts at various times, consider making your family member an authorized user on your credit card(s). Some companies will allow you to set a separate credit limit for the authorized user. Your family member will increase their credit score while you will reap the credit card rewards or points on their spending.
Pros and Cons of a Family Loan
There are reasons a family loan can make sense, but there are also risks to any lending. If you are discussing whether to make a family loan, always consider:
Credit History
Eligibility for a family loan is not based on the borrower’s credit score. Especially if the borrower has an adverse history, such as bankruptcy, family loans may be their only credit option.
Flexible Terms
Family loans can come with little or no structure and can be paid back on a non-traditional schedule. A family lender may also offer a lower interest rate or even require no interest at all.
Family Relations
A successful personal loan can bring family members closer together and put the entire family on a better financial footing, especially if the recipient uses the loan to further a business. The downside is that if the loan goes sour, family members can end up aligned against each other.
No Benefits
As intra-family loans are typically offered at below-market interest rates, the lender sacrifices more beneficial ways of investing those funds. Additionally, because the family loan is not reported to the credit bureaus, the borrower will not improve their credit score through on-time repayment of the loan.
Tax Law for Family Loans
Family loans are governed by tax laws that impact both the lender and the borrower. The IRS sets a minimum rate that lenders need to charge on all loans over $10,000, or else the lender must pay taxes on the foregone interest they could have earned. As of 2021, this applicable minimum rate is 0.14%.
Therefore, it may be smart to charge a small amount of interest rather than offer a family loan interest-free. While that may appear counter-intuitive, it is always best to understand how taxes impact any business transaction.
Write a Family Loan Agreement for Your Safety
If you believe a family loan is your best option, make sure to protect yourself when lending by creating a loan agreement between you and the borrower. Signing this agreement, which may also be called a promissory note, will protect you from future misunderstandings.
The loan agreement should be more explicit than an IOU, detailing at least:
- The amount of money borrowed
- The identity of the lender and borrower
- The interest rate
- The terms of the repayment schedule
- Pre-payment penalties or late fees
- A preferred method of dispute resolution
Making the expectations clear in writing means neither party will be blindsided in the future. The borrower will know precisely what they have to pay and when. An agreement also can be evidence for the IRS that you have complied with all tax laws.
Formalizing a family loan through a well-drafted agreement allows you to access the benefits of avoiding the banking system while protecting your future financial and personal relationships. You can use our contract maker to create a comprehensive and legally-binding family loan agreement, no lawyer required!
Helpful Resources:
When you need some extra money, you might consider borrowing from a family member to. A family loan can help out when you do not want to turn to a bank for help with a short-term cash flow problem. And if you have poor credit or limited income, a family loan can be the only option for accessing credit.
What Should You Know About Family Loans?
With an intra-family loan, the lender is often a parent or grandparent, but recently more adult children have been providing loans to their parents. The interest rates and repayment terms vary and often lack structure. Family loans are quite common in the United States, as studies report 60% of people have received funds that they anticipated paying back from a family member (or close friend).
If you are considering asking a family member for a loan or are thinking about providing funds to a family member, there are numerous potential outcomes.
Alternatives to Family Loans
Before you hand your kid a stack of cash or turn over your credit card to your niece, make sure that both the lender and the borrower are confident a family loan is the best solution. A different arrangement may lead to a better outcome, depending on your exact situation.
Some alternatives to a family loan include:
Gifting
The IRS allows each individual to gift anyone else up to $15,000 per year. Merely giving the money to your family member without the expectation of repayment can avoid future disagreements. Make sure you consult with a tax professional before offering or accepting any monetary gifts.
Personal Loans
Keeping your business loans separate from your personal life can prevent uncomfortable conversations around the holiday dinner table. If the borrower has the credit history to take out a personal loan from a bank, it may be the smart choice.
Co-Signed Loans
The need for an intra-family loan typically arises because the borrower may not have the credit history to access additional funding from the formal banking system. In these situations, co-signing a loan for the borrower may be a better solution than lending the money directly. However, keep in mind that you are liable for the loan’s total amount as a co-signer if the borrower is unable to repay.
Authorized User
If the borrower needs access to smaller amounts at various times, consider making your family member an authorized user on your credit card(s). Some companies will allow you to set a separate credit limit for the authorized user. Your family member will increase their credit score while you will reap the credit card rewards or points on their spending.
Pros and Cons of a Family Loan
There are reasons a family loan can make sense, but there are also risks to any lending. If you are discussing whether to make a family loan, always consider:
Credit History
Eligibility for a family loan is not based on the borrower’s credit score. Especially if the borrower has an adverse history, such as bankruptcy, family loans may be their only credit option.
Flexible Terms
Family loans can come with little or no structure and can be paid back on a non-traditional schedule. A family lender may also offer a lower interest rate or even require no interest at all.
Family Relations
A successful personal loan can bring family members closer together and put the entire family on a better financial footing, especially if the recipient uses the loan to further a business. The downside is that if the loan goes sour, family members can end up aligned against each other.
No Benefits
As intra-family loans are typically offered at below-market interest rates, the lender sacrifices more beneficial ways of investing those funds. Additionally, because the family loan is not reported to the credit bureaus, the borrower will not improve their credit score through on-time repayment of the loan.
Tax Law for Family Loans
Family loans are governed by tax laws that impact both the lender and the borrower. The IRS sets a minimum rate that lenders need to charge on all loans over $10,000, or else the lender must pay taxes on the foregone interest they could have earned. As of 2021, this applicable minimum rate is 0.14%.
Therefore, it may be smart to charge a small amount of interest rather than offer a family loan interest-free. While that may appear counter-intuitive, it is always best to understand how taxes impact any business transaction.
Write a Family Loan Agreement for Your Safety
If you believe a family loan is your best option, make sure to protect yourself when lending by creating a loan agreement between you and the borrower. Signing this agreement, which may also be called a promissory note, will protect you from future misunderstandings.
The loan agreement should be more explicit than an IOU, detailing at least:
- The amount of money borrowed
- The identity of the lender and borrower
- The interest rate
- The terms of the repayment schedule
- Pre-payment penalties or late fees
- A preferred method of dispute resolution
Making the expectations clear in writing means neither party will be blindsided in the future. The borrower will know precisely what they have to pay and when. An agreement also can be evidence for the IRS that you have complied with all tax laws.
Formalizing a family loan through a well-drafted agreement allows you to access the benefits of avoiding the banking system while protecting your future financial and personal relationships. You can use our contract maker to create a comprehensive and legally-binding family loan agreement, no lawyer required!
Helpful Resources:
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