As the Federal Reserve seeks to combat inflation, interest rates are on the rise. That means the cost of borrowing money is going up—30-year mortgages are now well over 5%!
So, where could one get a reasonable loan?
Because the terms are negotiated between loved ones, family loans can help borrowers secure financing at reasonable rates. However, mixing family and money can make this more complex than other types of loans.
What are family loans, and how do they work?
We will review them in this article so you can better understand how using one might, or might not be, beneficial for you and your family.
What Are Family Loans?
Also known as intra-family loans, these loans are exactly what they sound like—loans made between family members.
The key difference is that they allow you to cut out the middleman, which is typically a bank. Structuring a loan in this way also opens up opportunities for ongoing funding and estate planning considerations.
Why would you consider granting a loan to a family member? Perhaps you want to help them buy a house, pay off their graduate school debt, fund a new business venture, etc., without cosigning a loan or jumping through other tactical hoops.
How To Structure A Family Loan
Even though the agreement is between family members, it’s often best to ensure that your loan is appropriately structured. In fact, keeping everything above board may be even more critical since it involves family.
- Documentation. At a minimum, put all the loan terms in writing—how much the loan is for, interest payments (if any), a timeline for repayment, and more. Establishing a thorough document that clearly lays out the terms and expectations keeping everyone on the same page long-term. And this discussion isn’t just about trust among loved ones. Without something official, it may be easy to forget or misremember details over time, which could cause unnecessary friction. A written document you can reference will help clear the air should someone not be on the same page.
- Interest payments. Since you’re not going through a bank, you don’t have to charge your family interest on the loan. But understand that this decision has advantages and drawbacks. By not charging interest, the government may view the loan as a gift. If the loan amount exceeds the annual gift exclusion amount of $16,000 in 2022, you’ll need to file a gift tax return with the IRS. But if the loan is under the annual exclusion limits, you likely won’t have to report it to the IRS. Even if you don’t intend to charge interest, it may make sense to set a low rate so you can circumvent gifting issues entirely.
- Taxes. While side-stepping the gift-tax issues, charging interest can impact your tax situation. The IRS will likely require you to pay income tax on the interest you charge, making it essential to keep a watchful eye on the guidelines. If your chosen interest rate falls below certain thresholds called the applicable federal rates, you could incur an income tax liability on the difference. In other words, the IRS could treat it like you’re getting the minimum amount when you’re really getting paid less.
The Pros of Family Loans
There are several key benefits that family loans may provide over traditional commercially-provided loans.
Because a financial institution isn’t involved, there is much less paperwork to worry about. There are no standard forms, contracts, or disclosures; the parties can draw up a simple agreement for each to sign.
Compared to mortgages, family loans are especially seamless. Because there are fewer lender-required hoops to jump through than with a mortgage, family loans can significantly expedite home closing.
A family loan can also be an effective way to bridge short-term goals. Often, people may otherwise pull from retirement plans in these cases, which incurs taxes plus penalties. The family loan may prevent that and save thousands of dollars.
Lastly, you can complete a family loan without a formal credit review that a third-party lender would require. If the borrower has a poor credit history, that can be a huge perk and may even provide them with an opportunity they otherwise wouldn’t have access to.
The Cons To Consider
Of course, there are some downsides to this strategy. If the borrower has poor credit or a short history, a family loan won’t help their credit score and is not factored into their history by the credit bureaus.
As mentioned, there may be tax considerations depending on how much money your family borrows and the interest rate you charge. Borrowers must understand how their particular loan will affect their tax bill.
Family loans can also be tricky if the lender dies before the loan is repaid. The loan documents need to address what happens if a family member dies prematurely:
Is the balance forgiven or taken against any inheritance?
It’s important to address the family member’s wishes in the estate plan because outstanding debts are part of the estate, and the executor will be responsible for collecting them.
When it comes to creating family loans, try to avoid assuming anything. Having in-depth conversations, getting the terms in writing, and spelling out action plans should something happen to either the lender or borrower brings clarity and organization to the process.
Know Your Goals and Set Clear Boundaries and Expectations
Whenever friends and family are in the mix, personal feelings come into play.
Try not to downplay this emotional factor when considering lending or borrowing via a family loan. If you’re the one giving the loan, be clear about what you’re willing to give and under what terms.
Once you’ve settled on the terms, cement them in writing and ensure all parties understand them clearly. Even if that feels a little awkward or too formal, you’re probably saving yourself a lot of stress and hassle over the long term. Clear and up-front communication tends to work best.
Respect your boundaries and family dynamic. Family loans can be an excellent planning tool and allow you to provide a lot of help to loved ones, but don’t get involved with a family loan if you don’t feel comfortable doing it.
Put the brakes on if you don’t trust the person asking for the money, you would take too much money away from your lifestyle goals, or you aren’t comfortable with the amount or reason for the loan. You want to make deliberate, thoughtful decisions with your money.
If you have questions about how family loans work, we can help! Schedule a meeting with us today, and we can help you determine if this arrangement could be a good fit for you and your family’s needs.