Family Loans: How to Approach Lending Money to Family
Should you lend to or borrow money from your family? Many people approach the idea of family loans with three simple words of advice: “Don’t do it.” Loaning money to family can result in a number of unsavory consequences, including ongoing debts, hurt feelings, strained relationships, communication breakdown, tax implications and more.
However, it isn’t always a bad idea to extend a family loan to your loved ones. Crystal clear communication about expectations, repayment and consequences should be a key element of any family loan.
Setting up a family loan agreement can help you track all of these decisions in a handy document that can be used for reference when needed.
In this article, we’ll cover…
What is a family loan?
When you lend money to or borrow money from someone you’re related to, you’re extending or receiving a family loan. Family loans can be a fast, easy way to help a loved one quickly access financial resources without incurring high rates of interest or going through the paperwork associated with a loan application. On the downside, family relationships could go awry if the borrower doesn’t repay their debt as expected.
A family loan isn’t considered a gift as long as there’s an expectation of repayment, but the rules are almost entirely up to the parties involved. Some of the variables to discuss with your family member include the amount to be borrowed, the interest rate, if any, and the terms of repayment. Be careful to note the tax implications that may be involved when lending or borrowing money within your family.
Create a family loan agreement
A family loan agreement protects both parties in the transaction, even if you feel confident that you won’t need it. With so much on the line, everyone benefits from clearly defined terms and conditions of repayment for future reference.
If your loan amount exceeds $10,000, the IRS requires a written agreement outlining the terms of the loan and repayment, as well as a minimum interest rate called an applicable federal rate (AFR). If you are borrowing or lending less than $10,000 between family members, you don’t have to worry as much about potential tax implications.
The following sections explain how you can incorporate these key components into your successful family loan agreement.
Creating an agreement document
A strong loan agreement not only protects both parties in the event of any discrepancies, but may also be legally required by the IRS if your loan amount is larger than $10,000.
A comprehensive contract should include the following details:
- The amount to be borrowed (loan principal)
- The interest rate on the loan, if applicable (you must charge interest if your loan amount is over $10,000)
- The method by which the money will be transferred and repaid
- The terms and amount of repayment (e.g., fixed installments at periodic times, or a lump sum on the final due date)
- Consequences of nonpayment, including legal action or taking ownership of any collateral
- Additional costs that may be associated with the loan, if any
- Potential modifications to the loan terms
- Signatures from both parties
If the borrowed amount is significant or if the loan is going toward the purchase of a large asset such as a home, you may want to consult legal counsel for input and have the document notarized for your protection.
Having these terms spelled out in writing simplifies the process of enforcing your agreement and protects both parties from misunderstandings in the future.
Tax implications
If your loan amount exceeds $10,000, the IRS requires a written agreement outlining the terms of the loan and repayment, as well as a minimum interest rate, called the applicable federal rate (AFR). This interest rate is updated each month, and the AFR varies based on the duration of your loan.
Note that the lender is not limited to charging the minimum AFR on a family loan; they can charge a higher rate of interest if they choose to do so. However, the IRS treats interest that should be earned on a loan exceeding $10,000 as income. So if you are lending money to a family member but don’t know the financial implications, you may find yourself on the hook to pay taxes on the amount of interest you should have earned on a five-figure loan, even if you don’t charge your borrower any interest.
The AFR can fluctuate from month to month based on a variety of factors, so it’s important to keep careful track of how and when the loan principal is repaid.
If you don’t want to deal with the hassle of tracking interest and worrying about income liabilities, you can consider gifting the money to your family member instead. As of 2022, you are allowed to gift an individual up to $16,000 without incurring a gift tax.
Nonpayment
Your agreement should include a section that outlines the consequences if the family loan borrower defaults on repayment, whether it’s temporarily due to an emergency or permanently. It can feel uncomfortable to consider this scenario, but it’s important to get this agreement in writing before money changes hands.
Record-keeping
Meticulous record-keeping will make a huge difference in keeping your family loan experience smooth and trouble-free. From the get-go, track each transaction as it exchanges hands, from the initial principal to each repayment. Where possible, use a system that allows both parties to see each transaction as it is logged, whether it’s a simple pen-and-paper notebook, online spreadsheet or dedicated accounting software system.
Not only will this benefit your relationship, but it will also help keep your finances neat and accessible if you need to report anything to the IRS or future inheritors.
Pros and cons of family loans
At the end of the day, you and your family members are the only ones who can determine whether or not a family loan is right for you. In any case, it’s wise to consider both the benefits and risks of a family loan.
Pros of family loans
Access regardless of credit: A family loan can be a helpful solution for borrowers who have a low credit score and would struggle to qualify for a traditional loan.
Lower interest rate: Family lenders may be willing to lend money with a much lower interest rate than would be available with a traditional loan.
Negotiation is possible: With family loans, a borrower may be able to discuss potential repayment solutions that are more creative than traditional lenders will offer.
Cons of family loans
Potential to damage relationships: Poorly communicated expectations and follow-through can lead to strife and resentment, not just for those involved but for the family and friends who are close to them.
May need to be disclosed to the IRS: If your loan amount exceeds a certain threshold, you may need to be vigilant to ensure the lender’s generosity does not cost them additional taxes or other fees.
No credit building: A family loan will not help you build credit through a history of responsible repayment, since your payments are not reported to any credit bureaus. If this is your primary goal, consider a personal loan, a mortgage or a small business loan that will report your payments to the applicable credit bureaus.
Alternatives to family loans
For many reasons, a family loan may not be the right option for you and your loved ones. Consider the following options if you’re looking for alternative ways to share financial resources.
Gift
If you are in a position to help a family member without the need for repayment, consider gifting them the sum needed instead. That way, you do not have to worry about potential income tax implications, and the recipient does not need to worry about gathering the funds needed to repay your generosity.
As of the time of writing, you are allowed to gift an individual up to $16,000 without incurring a gift tax. If you wish to gift more money than that, speak with a financial professional about the potential tax implications.
Cosign
If you are willing to help a family member qualify for a loan but do not want to personally dip into your own financial reserves, consider cosigning for a loan with the borrower. This allows you to keep your own money free while adding the weight of your financial history and stability to bolster their application.
Note that you will be responsible for repaying the debt if your family member defaults on their loan, so enter this financial arrangement with the same caution that you would in extending a personal loan.
Small business loan
If you are seeking funds to start a small business, consider applying for a small business loan instead. Not only can a dedicated business loan help you build up your business creditworthiness, but you may be able to qualify for significantly more funding than your family may have to offer, allowing you to get a jumpstart on investing in your company.
Family loans: FAQ
Do I have to report a family loan to the IRS?
Yes, family loans should be reported to the IRS. If you wish to lend without charging interest, note that you may trigger IRS gift tax rules if the amount exchanged is past a certain limit ($16,000 in 2022).
How much money can I lend to a family member?
Theoretically, you can lend or borrow as much money as you are comfortable exchanging. However, the lender may need to pay taxes on interest earned from loans over $10,000.
Do I have to pay interest on a family loan?
The lender must charge a minimum rate of interest on loans exceeding $10,000, as well as pay income tax on the earned interest.
Is loaning money to family a good idea?
Lending between family members can be risky without the right protective measures. But with a solid loan agreement and responsible measures in place to protect both parties, a family loan can be really beneficial for borrowers who need a boost of financial support from the right people.