One of the best places to get a loan is from a family member. People can borrow money from siblings, parents, and other relatives for various reasons. For example, kids could need a loan from their parents to buy a house, or a sibling could need a loan to buy a new car. As a borrower, a family loan has many benefits.
But there are also disadvantages to family loans that impact both the borrower and lender. It’s important to consider the financial, personal, and legal implications when pursuing a family loan.
If you’re interested in a family loan or a family member has asked you for one, here are a few things you need to know.
What Is a Family Loan Agreement?
A family loan agreement, also known as an intra-family loan, is a contract that outlines the terms of a loan made between family members. In family loan agreements, the lender and borrower may be blood relatives or related by marriage.
When you want to have a family loan documented, you would typically use a specific loan agreement called a promissory note. These contracts are simpler versions of the loan agreements you get from traditional lenders such as banks. A promissory note may be ideal as it’s an informal loan agreement contract between family members.
Pros and Cons of Borrowing From Family
There can be advantages and disadvantages when lending money to or borrowing money from family. A family loan needs to be mutually beneficial to maintain the relationship between parties. But what’s most important is that the lender and borrower need to be aware of the tax implications, risks, and other options available to them.
Advantages of Family Loans
Family Loans are Flexible
One of the biggest advantages of receiving a loan from a family member is that there can be greater flexibility in the terms of the agreement. It can lead to more favorable loan terms compared to loans from traditional lenders. For example, the lender can be flexible with the amount you’re borrowing, the interest rate, and the repayment schedule.
It isn’t uncommon for there to be agreements where a family member lends the borrower 100% of the requested amount, with a very competitive interest rate and a loose repayment schedule.
Family lenders can also be more forgiving of changes to your circumstances, such as losing a job. So they could lower or pause repayments until your situation improves. They may also waive late payment fees.
Family Loans Have Easy Approval
When you apply for a loan from a traditional lender such as a bank or a credit union, you will have to go through an application process. They may check your credit rating and income and require you to provide identification and documents like W-2s and pay stubs. If you don’t meet their criteria, you won’t be eligible for a loan. But if you borrow from family, they’re more likely to give you a loan, even if you have an unflattering credit score or low income.
You Can Avoid Predatory Lenders
Some people find it difficult to apply for a personal loan from traditional lenders. They may be interested in seeking a loan from lenders who offer no credit checks or payday lenders. However, these lenders tend to charge interest rates that are incredibly high and likely to leave the borrower in an even worse financial position. A borrower can prevent this by getting a family loan where they can negotiate better terms for themselves.
Disadvantages of Family Loans
Family Loans Can Risk Relationships
It can be tempting to help out a family member who needs financial assistance. You may feel confident that they will eventually repay you in full. But there have been many instances where this hasn’t been the case, and a family member could not pay back the loan. This can damage the relationship between the family members, especially if the loan was a significant amount of money.
It’s important to have the proper safeguards to ensure the borrower doesn’t end up defaulting on the loan. Before lending money, you should also consider an eventuality where your family member cannot pay you back and how that might affect your financial goals.
Family Loans Have Tax Implications
Family loans still have to follow tax rules, and there can be tax consequences for both the lender and borrower:
- Lender – If you lend money to a family member with interest, the IRS will consider that interest as taxable income, and you’ll be liable to pay tax on it.
- Borrower – If the lender cancels the debt altogether, the IRS will likely consider the remaining amount as taxable income.
Family Loans Won’t Improve Your Credit History
When you usually report your payments to traditional lenders, it can increase your credit score and make you more eligible for credit-based applications in the future. These applications could be for a mortgage or even a car loan. But as your family member is not a part of the main credit bureaus, reporting your repayments will do nothing to help your credit score.
What To Include in a Family Loan Agreement
Include the necessary terms when writing your family loan agreement. The IRS will deem your loan a gift if you omit them, and gifts can have tax consequences.
As of 2022, every individual is entitled to a $16,000 annual gift-giving limit. But if you lend a family member a larger amount, you will have to file a gift tax return.
To ensure your loan is legitimized in the eyes of the IRS, your loan agreement should have:
A Repayment Schedule
You may feel like you don’t have to iron out the details with a family member. Still, it’s a good idea to include a repayment schedule. Speak with the borrower and agree on when and how they could repay the loan. For example, they could make monthly payments or repay the loan in full by a certain date.
Interest Rates, if Applicable
Your loan agreement should include the interest rate if you’d like to be compensated for the loan. The minimum interest rate, commonly known as the applicable federal rate, applies to amounts above $10,000. If the interest rate it’s below-market, the IRS will tax you for what they think you should be charging the borrower.
If you decide not to charge any interest on the loan, the IRS is likely to consider the loan as a gift.
The Loan Amount and How It’s Going To Be Used
You should specify the amount you’re going to lend the family member and clearly state the purpose of the loan. It’s good practice for both parties to understand why the loan agreement is being made. This is for record-keeping purposes and holds the borrower accountable if they use the loan for a different purpose.
Consequences for Nonpayment
If your family member cannot make the agreed-upon payments, there should be provisions in the agreement that detail what will happen. As a lender, the consequences are entirely up to you. Still, they can’t be anything that would contradict the law, such as charging excessively high interest rates or using illegal debt collection practices. Typical consequences could be charging late fees or taking collateral as a substitute for payment.
As the borrower signed a contract, you are entitled to seek a court judgment if they don’t cooperate with the terms of the agreement. The judge could then have the borrower’s wages garnished or order a property lien to satisfy the repayment of the loan.
Sometimes, the borrower may find themselves in an emergency where they are temporarily unable to make the repayments. For example, they could have an injury that affects their income-generating ability. The loan agreement should consider this and have a suitable consequence. You could have a grace period or temporarily reduce the repayment amount until they can resume the normal payment schedule.
Alternatives To Family Loans
Loaning to family members can get messy, and if you’d rather avoid the potential for issues to arise, you can consider these other options:
Give a Gift Instead of a Loan
If you can afford to give money to your family member with no strings attached, you can choose to give them the requested amount as a gift. The annual gift-giving limit for 2022 is $16,000. So if you lend a family member less than that amount, you won’t have to file a gift tax return.
You won’t necessarily have to pay any gift tax if you lend a family member more than that amount. It just means you’ll have more paperwork to deal with.
You will have to file IRS Form 709 and report the amount exceeding the limit. For example, if you gift your brother $20,000, you’ll have to report the excess $4000 in your gift tax return.
Get a Personal Loan and Have a Family Member Co-Sign
A family member may not be able to give you money with no expectation of repayment. If that’s the case, you might be able to get a personal loan from a traditional lender if they accept family members as co-signers for the loan agreement. In this arrangement, the family member will be obligated to make the repayments if you are unable to.
When a family member co-signs a loan, they need to keep in mind that their credit rating is at risk, and late payments can negatively impact their credit.
Get a Business Loan (if You’re Starting a Business)
If you need a loan to start a business, applying for a business loan may make more sense. This kind of loan can often provide more financial assistance than a family member. Various options are available, from business credit cards to microloans from institutions such as the Small Business Administration.
Be an Authorized User on Your Family Member’s Credit Card
When your family member isn’t willing to co-sign a loan or lend money, you can instead get them to add you as an authorized user on their credit card. It’s a great way to build your credit score.
Once your personal details are added to the credit card account, the responsible credit behaviors of the primary cardholder will start to impact your credit score positively. Over time, this will help you become more eligible for loans from traditional lenders.
Family Loan Agreement Frequently Asked Questions
No, you don’t have to charge interest on a family loan. However, interest-free loans are considered gifts by the IRS, and if they are above the annual gift-giving limit, you will have to file a gift tax return.
If you want to avoid filing a gift tax return, you need to set the interest rate at the minimum rate the IRS will allow.
Yes, you can write off a loan to a family member. But there are certain actions you must have performed before you are allowed to do that. You must have:
- Created a loan agreement with the necessary paperwork
- Charged interest on the loan
- Made attempts to recover the debt
Without performing the above, the loan may be considered as a gift by the IRS.
No, the money you borrow from your parents isn’t taxable. In most cases, a parent-to-child loan agreement has the expectation that the child will repay the amount to the parent. The IRS would consider this arrangement a loan and therefore exempt from taxes. However, if your parents gave you money without expecting to get repaid, it would be viewed as a gift.
If the amount is above the annual gift-giving limit, your parents will have to file a gift tax return. As the borrower, the IRS would see the gift as income, meaning you are still liable to pay income tax on the gift amount.
If you want to avoid paying income tax, you must make sure that you create a loan agreement with your parents with the minimum interest rate applied and other necessary terms mentioned above.