Friends, family, and financial institutions may have more in common than you think. According to the Census Bureau’s 2022 Household Pulse Survey, over 25 million consumers had to lean on their support network for financial assistance, up from 19.1 million in 2021.
The most popular reasons for asking family members or friends for a loan are to start a business or purchase a home. According to Chamber of Commerce.org, 16% of businesses are funded by bank loans, while loans from family and friends account for 2%-6% of initial small business funding.
The National Association of Realtors said that 52% of first-time home buyers used money from family, primarily parents or friends, to buy a house.
There are other circ*mstances for seeking a loan from family or friends, such as buying a car, a computer or something more personal like an engagement ring. It also may be a good place to get a loan if you are unexpectedly unemployed or get hit with a sudden illness.
How to Borrow from Friends or Family
The main advantage of receiving a loan from a friend or family member is that your “lender” is more likely to be flexible about the amount borrowed and payment arrangements. That means you could borrow 100% of the amount you need at a very low-interest rate – possibly 0% — and get an affordable monthly repayment schedule.
Treat a personal loan issued by a loved one with the same respect and professionalism you would a loan from a bank.
If you plan to borrow money from a bank, credit union, or other lending institution, you must sign a legal contract outlining your obligations to the lender: On-time payments for the duration of the loan agreement. This contract is called a promissory note.
Should it be any different if you borrow money from friends or family? Not really. Even if they’ve known you for years, they still need assurance that you’ll repay them as promised. Knowing them well doesn’t override the obligations and responsibilities of taking on a loan.
Draw Up a Loan Agreement
It is wise to draw up and sign a loan contract regardless of your relationship with the lender. This protects both parties in case of a disagreement. A loan agreement between two individuals is more simplistic but similar to a standard bank promissory note.
Basic terms for a loan agreement with family or friends should include the following:
- The amount borrowed (principal)
- Interest rate (if applicable)
- Repayment terms (monthly installments over a set period or a lump sum on a specific date)
One of the most important things to address in a loan contract with a friend or family member is what will happen if you can’t pay. The loan agreement should clearly state the lending party’s recourse in case of non-payment, including:
- Adding additional costs to the loan
- Modifying the loan terms
- Taking ownership of the collateral
- Pursuing legal action
What Happens If You Default on a Family/Friends Loan?
Like any loan contract, you’re legally on the hook for the debt. If you fail to abide by the terms of the agreement, your lender — in this case, your loved one — can take legal action against you. With the contract as proof, the lending party can sue in small claims court, get a judgment and then pursue collection activities on the loan — such as wage garnishment or property liens — just like other creditors.
If you cannot negotiate more reasonable loan terms privately, a lawyer can either negotiate on your behalf to include part of the balance due in a debt settlement agreement or add it to a debt consolidation loan. Taking action before a judgment is entered in small claims court is vital because the lending party can often pursue your assets, bank accounts, and wages.
Preserving the Personal Relationship
Relationships built over years or even decades crumble when conditions of a loan agreement are ignored or broken.
If you fall behind while repaying a family loan, keeping the lines of communication open is crucial. Good communication is the best way to avoid animosity with family and friends who have loaned you money. They want to know how the project or business is doing and whether this loan will be paid off.
Write everything down and ensure both sides understand the details of the agreement. Both sides should be realistic about what to expect.
What to Do If You’re the Lender
The lender has the most to lose when there is a loan agreement with family or friends. They not only put their money at risk but also put their reputation and relationship in danger. They could lose it all – money, family, and friendships – if things go wrong, and they stand to gain little more than a few dollars of interest if everything goes right.
Here are a few things, some very stark, to consider before making the loan:
- What is your family’s net worth, and can you afford to tie up your money for weeks, months, or years?
- Would you pursue foreclosure on the borrower or sue if they default on the loan?
- Would you impose penalties for late payments?
- Would you get involved in the project or business to help get your money back?
- Have all other options been exhausted: Banks, credit unions, or other family members?
- If lending institutions won’t give them money, do you want to take on the risk?
If you have examined all the adverse outcomes of making a family loan and decided to go through with it, here are a few steps that might help produce a positive outcome.
- Ask for a plan. The borrower should furnish details of the money’s intended use, the schedule for repayment, and what will happen if they default on the loan.
- Review the borrower’s finances and help them set up a budget that includes your monthly repayment.
- Make sure they understand this is a loan, not a gift.
- Agree on a set of fair terms and enforce them.
- Keep your distance. Just because you give someone a loan doesn’t mean you can meddle in the project or business.
- Get it down on paper. It’s easier to settle arguments when everything is written down – and signed!
What Are the Tax Implications of a Family Loan?
Dealing with the IRS is a critical aspect of loans between family members or friends. Both borrower and lender have responsibilities, though most of them fall on the person lending the money.
The first thing the IRS wants is clear proof that this is a loan and not a gift. That means charging and collecting interest under the IRS rules for the applicable federal rate. As of April 2023, the minimum annual rate was 4.86% for short-term loans; 4.15% for mid-term loans; 4.02% for loans more than nine years.
If the parties involved are not paying and collecting at least that much interest, the IRS could deem the money a “gift” and apply gift taxes, depending on the amount.
The next step is to draw up legal documents for the loan. If the loan is for a home, that includes a deed of trust and recording the loan with the county.
The two sides must sign a promissory note that spells out the interest rate, terms and conditions, length of repayment period, and ability to transfer the loan to another party.
There also should be an amortization table showing the amount of principal and interest paid, and the balance due each month for the lifetime of the loan.
The lender must file IRS form 1098 stating how much interest the borrower paid for each year. The lender also must file IRS form 1099, which states how much interest they received on the loan, and report that amount on their tax return. This is an essential step in the loan process, as there are severe tax consequences if any of these steps are missed.
Pros and Cons of Family Loans
Family loan agreements come with pros and cons, just like any other type of loan. Your relationship with your loved ones will be a primary factor in determining whether this method is wise. Below we compare the benefits and drawbacks of taking out a family loan.
Pros
- Easier approval: Your relatives aren’t unlikely to require a credit check or background check before agreeing to lend you money. There are other ways to ensure both sides feel confident about the deal. Signing a contract can help protect the interest of both parties, while supplying collateral can help reassure your relative that their assets are secured.
- Cheap, or no interest: There won’t be many fees associated with a family loan. Origination and processing fees are standard when borrowing from financial institutions, but most relatives loan money out of compassion and without expecting much monetary gain.
- A low credit score is irrelevant: If you’re struggling to pay debts, your credit score has likely suffered in recent months. This is usually a major roadblock for borrowers seeking financial aid, but your relative will probably be more understanding than a bank.
- Avoid risky options, like payday loans: Reach out to a friend or relative for help before resorting to high-interest payday lenders. The average payday loan is a relatively small amount of $500 or less. Many friends or family members would be comfortable loaning or donating that amount to a good cause or helping someone they care about.
Cons
- Potential for family conflict: Borrowing money from a friend or relative can lead to disputes over repayment or awkward relations down the line. Your uncle may have had other plans for the capital your aunt was willing to loan you.
- Tax implications: Certain tax implications may further complicate receiving a family loan. The friend or relative who loaned the money must file a gift tax return for interest-free loans over $17,000. If the loan includes interest, the ‘lender’ must report what they earn as income.
- Doesn’t help to build credit: Your friend or relative lender will not report your payments to the credit bureaus. That means you won’t receive ‘credit’ for making on-time payments, which is a way to increase your credit score.
Alternatives to Loans from Family Members
According to a 2022 CreditCards.com survey, ‘many who lent money to family and friends either lost the money, damaged their relationship, negatively impacted their credit scores and even got into physical altercations with the borrower.’
There are alternative sources of money if you want to avoid the genuine possibility that taking or giving a loan to a family member or friend will result in a negative outcome.
Admittedly, tapping into sources for mortgage loans, house renovations, or car loans can be challenging. Still, if you’re looking to start a business, the Small Business Administration is a government agency that serves small businesses. They offer a variety of loan programs, including a General Business Loan that could get you $50,000 to $250,000. The SBA also has a Microloan program that offers up to $50,000 for startups and some nonprofit childcare centers.
Online, there are peer-to-peer lending sites like Lending Club and Prosper or crowdfunding sites like Kickstarter and Crowdfunder that may deliver the loan you don’t want to ask Mom and Dad for.
If you’re looking for something that will help with a renovation or be a down payment for a home or new car, you could consider borrowing from your 401(k) retirement fund.
If you already own a home and have enough equity, doing a home equity loan or home equity line of credit (HELOC) could solve the problem.
