When you need money fast, turning to loved ones for help is often a hassle-free option. Borrowing from friends and family members is surprisingly common, given that many people warn against it. About 20% of U.S. adults receive financial support from family members or friends, and 1 in 3 adults provide financial support to others, according to the Consumer Financial Protection Bureau.
Borrowing from family members and friends has several advantages, including that you avoid credit checks, underwriting hassles and concerns about your debt-to-income ratio, says Ann Covington Alsina, certified financial planner and founder and principal at CovingtonAlsina in Annapolis, Maryland.
“When you borrow money from friends or family, the process is fast and easy,” Alsina says.
However, these types of loans also come with drawbacks, such as the possibility that borrowing will strain relationships. Here’s what to know before you borrow within your family.
[Read: Best Personal Loans.]
What Is a Family Loan?
The concept of a family loan may sound fancy, but it simply represents a lending agreement between family members that involves no bank or traditional lender.
A family loan can be for any reason. However, you will need to be aware of the tax, gift and estate implications of your loan.
When Should You Consider a Family Loan?
A family loan can make sense for “borrowers who have no credit history or poor credit” but the means to pay back the loan, says Mitchell Kraus, certified financial planner with Capital Intelligence Associates, Santa Monica, California.
Those borrowers might have a difficult time securing a loan through a bank, credit union or other lender. If you need money quickly or inexpensively, you may also be a good candidate for a family loan.
Pros and Cons of Family Loans
Pros:
— Skip the complicated application process. You won’t need a credit check or have to provide documents such as pay stubs and tax forms.
— Save money. You can get a lower rate than if you were borrowing from a traditional lender. A family member is unlikely to charge late fees and origination fees.
— Avoid a risky loan. A family loan can help you avoid risky choices such as payday and pawnshop loans.
Cons:
— Potential for family conflicts. Problems can arise when a borrower fails to pay the loan as agreed, says Ashley Folkes, certified financial planner with Inspired Wealth Solutions in Hoover, Alabama. “I have seen how this does not make for a nice, peaceful Thanksgiving dinner,” Folkes says. Loans can also breed resentment among family members. If you lend money to one child, Kraus says, be prepared to lend to the others. “We’ve seen many families fall apart because the children think they aren’t being treated the same way as their siblings,” Folkes says.
— No credit-building opportunities. On-time payments for a family loan are not reported to credit bureaus, helping you improve your credit score.
— Tax implications. The lender has to follow certain tax rules that can complicate a family loan. Those include filing a gift tax return for interest-free loans of more than $17,000 and reporting interest earned as income.>
Best Practices for Family Loans
If you are considering a family loan, take steps to head off potential problems.
The biggest source of problems, Kraus says, is misunderstandings about payment schedules, including payoff expectations. “For this reason, we always suggest that the terms of the loan be in writing,” he says.
Everyone should sign the loan terms and get a copy of the agreement, the CFPB recommends.
You can find many loan contracts online, which can help you create your own. If you choose not to use a template, you can write a legally binding contract as long as you include:
— The effective date of the loan.
— Which state’s lending laws apply if the lender and borrower live in different states.
— Full legal name, Social Security number, phone number and address for borrower and lender.
— Loan amount.
— Interest, if applicable, specifying the percentage amount and how often it will accrue.
— Repayment details, including installment amounts and due dates.
— Late fees, if applicable, including when they apply and amount.
— Collateral, if applicable, with specific details.
— Prepayment, specifying whether early payment is allowed or a penalty applies.
— Default, including how many payments the borrower has to miss and what happens when the loan is in default.
— Co-signer, if applicable. The lender might require a co-signer to pay your balance if you default. The co-signer must review and sign the contract.
[Read: Best Low-Interest Personal Loans]
Tax Implications of Family Loans
You can gift up to $17,000 per person, or $34,000 per couple, in 2023 before you must report it to the IRS. The donor is responsible for paying the gift tax.
You won’t necessarily owe taxes on that amount, though, because of the lifetime gift exemption. That’s the total you can give away free of gift taxes during your life, according to Charles Schwab. In 2023, that amount stands at $12.92 million.
The IRS also mandates that loans of more than $10,000 or that are used to generate income must be charged a minimum interest rate. The applicable federal rate is about 3%. If you fail to charge an adequate interest rate, the IRS could tax you on the interest you could have collected but did not, Charles Schwab reports.
Alsina stresses the importance of not being too casual when lending money to loved ones. “If the loan is over the annual gift tax exclusion, it should be documented as a loan,” she says.
Because of the potential tax implications of a family loan, particularly for wealthy people, you may want to consult an attorney, tax professional or financial adviser before pursuing this option. That is especially true if you plan to lend a large amount of money.
[Read: Best Home Equity Loans.]
Alternatives to Family Loans
Although family loans can be good resources for some borrowers, they are not always your best — or only — option. Other choices can include:
— Using a personal loan, especially one with a co-signer to improve your odds of approval.
— Borrowing against the equity in your home with a home equity loan or line of credit.
— Opting for a cash advance on your credit card.
— Buy now, pay later can split a bill for a large purchase into smaller payments.
— Asking for gift money if a family member can afford it and agrees a loan could be risky for the relationship.
Another simple and potentially less troublesome way to gain access to cash is to take steps to bring in more income, such as through a part-time job or side hustle, Alsina says. “You can also generate income by decluttering and selling unnecessary items,” she says.
You might also think about turning to your retirement funds, thanks to the federal SECURE 2.0 Act. Starting in 2024, the measure allows taxpayers to access up to $1,000 for certain emergencies and avoid the 10% early withdrawal penalty. The withdrawal can be repaid in three years.
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What Is a Family Loan? originally appeared on usnews.com
