At a Glance
Sometimes the best bank to deal with is the one closest to home: your family. But loved ones and money are often like oil and water and can’t (or shouldn’t) mix. If you’re considering borrowing or lending money within the family, there are a few things you should know first.
In this article, you’ll learn:
What is a family loan?
A family loan is a loan between family members and can be a real lifesaver when you need some extra cash to tide you over or tackle an unexpected bill. But, fair warning, there might be some tax stuff to consider, and it could get a little awkward if payments start showing up late (or not at all).
With a family loan, you and the other party will set up an agreement that details the amount of money being borrowed, the interest rate (if any), and the payment terms. It’s also a good idea to establish, in writing, what happens if the loan cannot be paid back. Think carefully before getting into a family loan agreement, as it could cause lasting damage to relationships if not handled properly.
Pros and cons of family loan
1. Rough credit
The majority of family loans won’t involve a background or credit check, saving the aggravation of navigating the world of credit reporting bureaus. Plus, your credit score won’t be a factor if you’re the borrower, making it easier to get “approved.”
2. Low interest rate
Most family loans will have a low interest rate that’s far under the current market rates, saving the borrower money and making it easier to pay the loan off faster.
3. Mutual benefits
A family in crisis is never good, and helping a family member in need will always have a positive ripple effect for everyone involved. Plus, the person lending the money may be able to earn a little extra with a small interest fee added.
4. Easy approval
You most likely won’t need to submit a stack of paperwork to your uncle just to borrow money, making it easier to get the money you need faster.
5. Cheap loans
By borrowing from family, you can avoid all the extra fees that are typically added to bank loans, such as origination fees, APRs, etc.
Since family loans typically aren’t a standard event in all families, there’s not much available in terms of boilerplate legal documents, meaning drawing up papers will fall on you and the other party. It may get uncomfortable creating contingencies in writing, but that discomfort is all the more reason to ensure everything is written down and understood by both parties.
2. Tax consequences
Gift taxes may come into play based on the amount borrowed and the interest rate offered. It’s a good idea to consult a CPA beforehand so that you understand the tax implications of borrowing money inside the family.
3. Family dynamic
Tensions can run high when money’s involved, especially if payment deadlines are missed, so make sure this is something you consider carefully before getting into a loan agreement with a loved one. Can your relationship, and the other family relationships, withstand losing thousands of dollars?
4. No credit building
One downside of not having your credit score involved in a family loan is that you can’t use the positive payment history to build your credit, making it difficult to get a better score that opens up your chances for competitive loan offers in the future from banks.
When to consider a family loan?
1. Loan terms
Are the loan terms you’re seeing in the marketplace favorable to your financial situation? If so, it might be best to avoid the awkwardness of dealing with your family. If the market is unfavorable, however, it might be best to sit down with your family to discuss if they’d be willing to help you out.
2. Legal remedies
Can you face your family member in court if things go sour? That’s an unfortunate reality many families have had to face when a family loan borrower couldn’t make their payments. There’s also the possibility that legal ramifications could cause you, either as the lender or borrower, to lose thousands of dollars in legal fees in addition to the loan that you should consider.
3. Restricted policies
Are there strings attached to this loan that make it unreasonable for either the borrower or lender? What about outside the family? Many banks won’t accept unsecured loans, like family loans, as down payment options for a mortgage. Are you sure you’ll be able to use the money the way you need to?
Alternatives to family loan
1. Personal loans
Personal loans from banks take the relationship woes out of borrowing completely and are a great way to get the money you need without involving family dynamics. Here are a few of the most popular personal loans we’re seeing now:
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2. Co-signed personal loan
If you’re not comfortable borrowing or lending directly with a family member, consider using a co-signer option. With a co-signed loan, the borrower can piggyback off of someone else’s credit score to get approved and get the money they need. The downside, however, is that if things go south with the loan, the co-signer will become responsible for repayment and will have their credit affected, too.
Compare: Personal Loans with a Cosigner
3. Cash advance apps
Cash advance apps offer the convenience of borrowing a few hundred dollars and repaying it on your upcoming payday. While they don’t impose interest charges, there may be subscription fees and “fast funding” fees involved. If you decide to use a cash advance app, it’s a good idea to consider it like a payday loan and ensure you have a plan in place to get the money back to the “lender” ASAP and avoid their fees.
4. Buy now, pay later
Buy Now, Pay Later (BNPL) options have become more popular thanks to e-commerce shopping carts adding them as a payment solution. BNPL works by spreading the cost of an item over a few payments, typically 4-6 months, letting you get the thing you need now, even if funds are short.
Related: Best Buy Now, Pay Later Apps
If a family loan isn’t working out the way everyone hoped, one option is for the lender to “gift” the remainder of the balance to the borrower. This can have tax implications, so consult a CPA before deciding whether or not to gift a significant sum of money to a family member.
Do you create a contract while taking a family loan?
It is always a good idea to have a family loan agreement or contract created when borrowing money from family members. Getting the details in writing ahead of time can save a lot of heartache and help both parties should the loan repayments stop coming.
Creating a Family Loan Agreement
A Family Loan Agreement is a legal document that details the process involved in borrowing an amount of money from a family member. The agreement should include:
- The amount being borrowed.
- Repayment terms include the installment amount, due dates, frequency of payments, and the date the loan will be repaid in full.
- The interest rate being charged.
- How the repayment plan will work if the loan is paid off early (prepayment penalties).
- Grace periods before late fees kick in (if any).
- What happens if the borrower cannot make payments temporarily.
- What happens if the borrower cannot make any further payments.
You should have this document notarized by a third party, too, to ensure everything is legal and above board.
Lending money to a family member is a tricky situation that can impact family dynamics in the short and long term. A good rule of thumb is to only lend amounts that you can afford to lose should your family member end up not being able to pay you back.
If your loan amount is over $10,000 then the IRS requires you to report it, along with a copy of the agreement that details loan terms.
You can loan a family member as much money as you like, but any amount over $10,000 will need to be reported to the IRS.
Yes, but the IRS requires any loan totaling $10,000 or more to be reported, along with a copy of the loan agreement that outlines the terms of the loan.
The IRS considers any money that’s given to a family member that’s above $16,000 to be a “gift” and therefore taxable via the Gift Tax. However, loans are not typically considered income and would not be taxable to the borrower. The interest rate attached to a loan, however, may be considered income for the lender.
The decision for whether or not to charge interest is up to the lender if the amount is under $10,000. For loans above $10,000, the IRS will expect the lender to charge at least the minimum interest rate set published at the time of the loan. This is known as the “applicable federal rate” and is published on the IRS’ website monthly.
The repayment schedule should take into account both family member’s financial situations and ensure it’s fair to all parties involved. Consider the income for both sides and what a reasonable amount of time should be before expecting the loan to be paid back in full. Be sure to add this amount (how much of an installment payment and how often it will be paid) to the family loan agreement.