Whether it’s to repay debt, put a down payment on a house, start a business or start a band, borrowing money from family members—or lending it to them—can be a risky business. And although all debt is risky, family loans carry different kinds of dangers.
Although family lenders don’t have to worry about pulling (or affecting) anyone’s credit score, private loans can quickly put otherwise strong relationships on ice if a borrower doesn’t pay up. Depending on the size of the loan, there may also be tax implications to complicate the situation even further.
That said, there are ways to more safely issue and receive family loans. Here are our best tips for stacking the odds in your favor.
Risks and Benefits to Both Parties
No matter which end of the dynamic you might find yourself on, there are both risks and benefits to family loans. But while both the borrower and lender risk putting a strain on the family relationship involved, the lender is likely to carry the greater financial risk—after all, it can be pretty hard to recoup your losses when you have no official financial authority.
Risks of Family Loans
Here’s how family loans can get tricky on both sides of the transaction.
For the Borrower:
• There is risk to the interpersonal relationship if the loan repayment plan falls through.
• Although avoiding a credit check—and possible negative credit consequences—is a plus, family loans also fail to help borrowers build their credit history since they’re not reported to credit bureaus.
For the Lender:
• There is risk to the interpersonal relationship if the loan repayment plan falls through—which puts the lender into a particularly tricky situation if they really need the cash back for their own financial situation.
• It’s easy for family lenders to lose their money outright if the borrower constantly defers to an IOU.
• Since family lenders don’t have any financial authority or backing, it can be difficult to recoup losses or enforce any substantial consequences for borrowers who go into default.
• If the loan is interest-free and for an amount in excess of the IRS gift tax exclusion , it may trigger the need to file a gift tax return (and potentially pay taxes on the gift).
Recommended: Should You Borrow Money from Friends and Family?
Benefits of Family Loans
Despite their risks, family loans do have some attractive qualities.
For the Borrower:
• Obviously, family loans present a low-cost alternative to traditional credit options. Family lenders usually don’t assess fees and may not charge interest.
• Family loans can carry much easier approval standards than their official counterparts. At a financial institution, borrowers are subject to a financial deep-dive involving their credit and employment history, income verification, and more. At the Bank of Mom & Dad, you’re probably a shoe-in; the only qualifier you need is your blood and a bit of good faith.
• Family loans often carry more flexible repayment standards than traditional loans do, and family lenders may be more lenient if the borrower faces extenuating circumstances that make it difficult to pay up.
• Failure to pay private family loans in a timely manner—or at all—won’t impact the borrower’s credit score the way such behavior would with a “real” loan.
For the Lender:
• It can feel rewarding to help out a family member in need, particularly if they’re putting the money toward a major life goal like homeownership.
• If the lender chooses to charge interest on the loan, they can earn interest as the loan is repaid.
Family Loans: Tax Implications You Might Not See Coming
It can be surprising to learn that shelling out some cash to Uncle Earl could be a big enough deal to land on the IRS’s radar. But it’s the truth.
Fortunately, most family loans fall outside of the purview of Uncle Sam. It’s only when they’re above IRS-defined amounts and interest-free that lenders have to worry.
Here’s how it works. If a family lender offers an interest-free loan to a family borrower, the IRS still sees the transaction as a loan—and assumes that the interest that should have been charged counts as a gift to the recipient. (The government publishes minimum interest rates on a monthly basis.)
That’s no big deal if the loan is for, say, $300. But if the unpaid interest—or unpaid loan balance—tops the annual gift-giving exclusion, which is $15,000 for 2020 and 2021, the lender might be responsible for filing a gift tax return and potentially paying extra taxes on the gift.
The IRS might also count the should-be interest toward the lender’s gross income, even if no interest is charged or received. Again, this isn’t a big deal with rates under 1% on loans of just a few hundred dollars, but with a big enough loan, it could impact the lender’s finances.
Tips to Make Borrowing and Lending Money to Family More Successful
If you’re considering lending money to or borrowing money from a family member, adding some structure to your loan can help minimize the risks while still allowing everyone involved to reap the benefits.
Planning it Out
All too often, a family loan takes place in a single, impromptu transaction: The borrower asks for some money, and the lender shells it out.
Instead, making a concrete plan together specifying all the loan’s terms, such as repayment installments and timing, is a better idea. Lenders might want to seriously consider charging interest, especially on large loans, due to the tax implications outlined above. Even a low-interest rate can motivate a borrower to get serious about repayment.
Making it Official
Clear communication and boundary-setting skills make pulling off a family loan a positive experience for all involved—and oftentimes, the best way to achieve those goals is to write things down.
Plus, drafting a formal money-lending contract makes your loan official in the eyes of the IRS, which can help keep loans from being classified as gifts for tax purposes.
Terms to include in your personal loan agreement include:
• The amount loaned.
• The loan’s repayment terms, such as frequency and amount, as well as a due date for when the loan must be repaid in full.
• The loan’s interest rate and fees, if any (for instance, the lender may decide to charge late fees if the loan repayment terms are not honored).
• Clauses concerning what happens if the loan is repaid early (is there a prepayment penalty?) and what happens if the borrower goes into default for any reason.
Recommended: Can I Pay off a Personal Loan Early?
If all of these caveats and warnings are making family loans sound like a less-than-prudent idea, there’s good news. Folks in need of a fast cash infusion do have other alternatives to consider before they start knocking on family members’ doors. (And yes, if a family member asks you to borrow money, you’re allowed to say no and steer them in a different direction.)
Obviously, the most ideal financial strategy for making a big purchase is to save your money so you don’t have to go into debt at all. Although this isn’t always possible or realistic, it might be worth taking a second look at your budget, working on a promotion, or starting up a side hustle to generate cash.
Furthermore, unsecured personal loans are available from certain banks and financial institutions and make it possible to fund a wide variety of expenses upfront. Of course, these may come with higher interest rates and more stringent qualification requirements than family loans do.
While borrowing money from or lending money to a family member can be tempting, it can have long-lasting impacts on interpersonal relationships as well as the lender’s finances. While drafting a structured loan agreement can help, personal loans can be an alternative worth considering.
SoFi offers a range of no-fee, low-fixed-interest-rate personal loans that can be used to fund medical expenses, home renovations, moving costs, and more.
Photo credit: iStock/Ridofranz
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