Has a friend or family member asked you for a loan? You’re not alone. Many people turn to trusted friends and relatives for help paying off debt, starting a business, or placing a down payment on a home or car.
This article will provide the information you need to know to come out of the process with your funds and your relationships intact.
To 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 reason.
According to a 2019 Bankrate survey of nearly 2,500 American adults, 60 percent have lent cash to a friend or relative, 21 percent have co-signed for a loan or rental, 17 percent lent their credit card. However, 35 percent of these lenders report that they lost their money, hurt their credit score, or experienced a damaged relationship due to the loan.
How can you lend your money in the right way? Your first step is to answer the following questions honestly. The first five questions deal with your finances, and the remaining ones relate to your emotions.
- Would you still have enough money reserved for emergencies after making the loan?
- Will the loan affect you reaching your financial goals?
- Do you have any consumer debt (such as credit card balances)?
- Would a late loan payment impact your monthly budget?
- If the loan is never repaid, how much would that loss affect your financial situation?
- Would the relationship be destroyed if the borrower never pays back the loan?
- Will the relationship be hurt if the borrower misses a payment?
- How would you handle it if the borrower spends money on luxuries (such as travel) before paying you back in full?
Your answers to these questions will help you decide if you are in the position to extend a loan to a friend or family member. While turning down a loan request can lead to hurt feelings, these responses also can help you explain your decision.
Is It Legal to Lend Money to a Friend?
It is legal to lend money to a family member or a friend. In fact, this type of loan has the same legal responsibilities as a bank loan. The debt becomes a legal obligation for the borrower to repay, and the lender can take legal action against someone who doesn’t repay a loan in small claims court.
Although it may seem formal for close friends and relatives to sign an agreement, it will help alleviate any conflicts or misunderstandings that may come up down the road.
Pros and Cons of a Family Loan
Here are the primary benefits and risks of a family loan.
Pros
Uncomplicated approval. Traditional lenders usually have a formal loan application process that includes a credit check, verification of income, and documents such as tax forms, W-2s, and pay stubs. A family loan can sidestep this lengthy process.
Lower interest rates. The borrower is entitled to charge an interest rate on the loan, but they may offer a lower rate than a traditional lender would offer on a similar loan. Borrowers also won’t have to pay an upfront origination fee that some lenders charge.
Beneficial terms. The lender and the borrower can agree to a loan timeframe that is more beneficial than a traditional lender might offer.
Hardship options. The lender in a friend or family loan is usually willing to pause or reduce payments if the borrower experiences a financial hardship, such as a job loss or illness.
Cons
Non-payment. Even someone you think is trustworthy and dependable can default on a loan.
Lack of funds. You will not have the use of the money you have loaned to a family member. This situation could be problematic if you experience a financial hardship of your own.
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 a traditional loan repayment would.
Potential for conflict or a damaged relationship. If payments are missed or not made at all, the relationship you’ve had with the borrower can become strained or even broken. Sometimes the resulting tension can affect your relationship with connected friends and family members as well.
Alternatives to Family Loans
As you weigh these pros and cons, you may be wondering if there are any alternatives to extending a family loan. The two main options are gifting and co-signing a loan.
Gifting. One way of alleviating the “will they” or “won’t they” question of whether someone will repay you is to offer the money as a gift. When you give the money with no expectation of being repaid, you can avoid the potential strain a loan could have on your relationship.
Before giving a financial gift in lieu of a loan, it’s wise to make sure that you will remain financially secure without that money.
Co-signing. Another option 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 the loan.
The downside to this arrangement is that failure to repay a co-signed loan can damage the credit score of both the borrower and co-signer, and the co-signer is responsible for the loan if the borrower does not make payments.
Tax Law for Family Loans
A loan is a legal contract, and as such, it has potential tax consequences for both the borrower and the lender. Borrowers have to repay the debt as agreed or claim the canceled debt as income.
Lenders who charge interest on a loan have to pay taxes on any interest earned from the borrower. As long as you charge an interest rate that is at least equal to the applicable federal rate (AFR), you can avoid tax complications.
If you don’t charge interest, the IRS requires you to pay taxes on what it calls “imputed interest charges.” Imputed interest is the amount of interest the IRS believes the lender should have charged for the loan. Uncharged interest can be applied as a tax-free gift when the total amount is less than the gift-tax exclusion amount for that calendar year.
It’s a good idea to check with your tax advisor before making a loan to a friend or relative.
Write a Family Loan Agreement for Your Safety
Creating a written loan agreement helps minimize your risks when loaning money to a friend or relative.
The most basic loan agreement between family and friends is often called an "IOU." These informal agreements are typically for small amounts of money and simply state the dollar amount that is owed. They do not include any interest provisions and may not state when payment is due.
Another type of family loan document is a promissory note. A promissory note usually includes an interest rate and the terms of repayment.
Usually, IOUs and promissory notes are signed by the borrower, although they may also be signed by the lender.
A loan agreement is a document that contains all of the details of the loan and is signed by both parties.
You can find a variety of free loan agreement templates online. Here are the basic elements a family loan agreement should include:
-
The date of the loan, the amount, and how it will be used.
-
Repayment terms, including required payment amounts, 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 penalty, include and how much interest will be saved with early payment.
-
What happens if the borrower temporarily misses a payment or stops payments entirely.
Many people have lost income and suffered other financial hardships due to the COVID-19 pandemic. If you have the financial means, extending 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 extend this hand up without damaging your own back account or ruining your relationship.
Helpful Resources:
Has a friend or family member asked you for a loan? You’re not alone. Many people turn to trusted friends and relatives for help paying off debt, starting a business, or placing a down payment on a home or car.
This article will provide the information you need to know to come out of the process with your funds and your relationships intact.
To 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 reason.
According to a 2019 Bankrate survey of nearly 2,500 American adults, 60 percent have lent cash to a friend or relative, 21 percent have co-signed for a loan or rental, 17 percent lent their credit card. However, 35 percent of these lenders report that they lost their money, hurt their credit score, or experienced a damaged relationship due to the loan.
How can you lend your money in the right way? Your first step is to answer the following questions honestly. The first five questions deal with your finances, and the remaining ones relate to your emotions.
- Would you still have enough money reserved for emergencies after making the loan?
- Will the loan affect you reaching your financial goals?
- Do you have any consumer debt (such as credit card balances)?
- Would a late loan payment impact your monthly budget?
- If the loan is never repaid, how much would that loss affect your financial situation?
- Would the relationship be destroyed if the borrower never pays back the loan?
- Will the relationship be hurt if the borrower misses a payment?
- How would you handle it if the borrower spends money on luxuries (such as travel) before paying you back in full?
Your answers to these questions will help you decide if you are in the position to extend a loan to a friend or family member. While turning down a loan request can lead to hurt feelings, these responses also can help you explain your decision.
Is It Legal to Lend Money to a Friend?
It is legal to lend money to a family member or a friend. In fact, this type of loan has the same legal responsibilities as a bank loan. The debt becomes a legal obligation for the borrower to repay, and the lender can take legal action against someone who doesn’t repay a loan in small claims court.
Although it may seem formal for close friends and relatives to sign an agreement, it will help alleviate any conflicts or misunderstandings that may come up down the road.
Pros and Cons of a Family Loan
Here are the primary benefits and risks of a family loan.
Pros
Uncomplicated approval. Traditional lenders usually have a formal loan application process that includes a credit check, verification of income, and documents such as tax forms, W-2s, and pay stubs. A family loan can sidestep this lengthy process.
Lower interest rates. The borrower is entitled to charge an interest rate on the loan, but they may offer a lower rate than a traditional lender would offer on a similar loan. Borrowers also won’t have to pay an upfront origination fee that some lenders charge.
Beneficial terms. The lender and the borrower can agree to a loan timeframe that is more beneficial than a traditional lender might offer.
Hardship options. The lender in a friend or family loan is usually willing to pause or reduce payments if the borrower experiences a financial hardship, such as a job loss or illness.
Cons
Non-payment. Even someone you think is trustworthy and dependable can default on a loan.
Lack of funds. You will not have the use of the money you have loaned to a family member. This situation could be problematic if you experience a financial hardship of your own.
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 a traditional loan repayment would.
Potential for conflict or a damaged relationship. If payments are missed or not made at all, the relationship you’ve had with the borrower can become strained or even broken. Sometimes the resulting tension can affect your relationship with connected friends and family members as well.
Alternatives to Family Loans
As you weigh these pros and cons, you may be wondering if there are any alternatives to extending a family loan. The two main options are gifting and co-signing a loan.
Gifting. One way of alleviating the “will they” or “won’t they” question of whether someone will repay you is to offer the money as a gift. When you give the money with no expectation of being repaid, you can avoid the potential strain a loan could have on your relationship.
Before giving a financial gift in lieu of a loan, it’s wise to make sure that you will remain financially secure without that money.
Co-signing. Another option 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 the loan.
The downside to this arrangement is that failure to repay a co-signed loan can damage the credit score of both the borrower and co-signer, and the co-signer is responsible for the loan if the borrower does not make payments.
Tax Law for Family Loans
A loan is a legal contract, and as such, it has potential tax consequences for both the borrower and the lender. Borrowers have to repay the debt as agreed or claim the canceled debt as income.
Lenders who charge interest on a loan have to pay taxes on any interest earned from the borrower. As long as you charge an interest rate that is at least equal to the applicable federal rate (AFR), you can avoid tax complications.
If you don’t charge interest, the IRS requires you to pay taxes on what it calls “imputed interest charges.” Imputed interest is the amount of interest the IRS believes the lender should have charged for the loan. Uncharged interest can be applied as a tax-free gift when the total amount is less than the gift-tax exclusion amount for that calendar year.
It’s a good idea to check with your tax advisor before making a loan to a friend or relative.
Write a Family Loan Agreement for Your Safety
Creating a written loan agreement helps minimize your risks when loaning money to a friend or relative.
The most basic loan agreement between family and friends is often called an "IOU." These informal agreements are typically for small amounts of money and simply state the dollar amount that is owed. They do not include any interest provisions and may not state when payment is due.
Another type of family loan document is a promissory note. A promissory note usually includes an interest rate and the terms of repayment.
Usually, IOUs and promissory notes are signed by the borrower, although they may also be signed by the lender.
A loan agreement is a document that contains all of the details of the loan and is signed by both parties.
You can find a variety of free loan agreement templates online. Here are the basic elements a family loan agreement should include:
-
The date of the loan, the amount, and how it will be used.
-
Repayment terms, including required payment amounts, 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 penalty, include and how much interest will be saved with early payment.
-
What happens if the borrower temporarily misses a payment or stops payments entirely.
Many people have lost income and suffered other financial hardships due to the COVID-19 pandemic. If you have the financial means, extending 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 extend this hand up without damaging your own back account or ruining your relationship.
Helpful Resources:
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