Lending money to relatives can have potential benefits and drawbacks for both the lender and borrower. However, family loans can work out well when planned for despite the risk.
Similar to other types of loans, family loans have legal requirements, tax implications and IRS guidelines to follow.
Family loans need clear communication, including upfront disclosure of repayment terms and the interest rate. A successful family loan will include the financial, personal and legal expectations of the lender and borrower in writing.
So before borrowing or lending money, here’s what you need to know about family loans and how they work.
What Is a Family Loan?
A family loan, also known as an intra-family loan, occurs when one family member lends money to another with the expectation of repayment. To count as a family loan, market interest rates and other guidelines outlined by the IRS should be followed.
Family loans are different from traditional loans. There are no credit pulls or checks, and the approval process is what can be agreed on. Defaults aren’t reported to credit bureaus, and the interest rates are lower than traditional loan types.
Family loans are also different from making a monetary gift to a family member. When money is gifted to a family member, they are under no obligation to repay or offer something in exchange for the gift. A relative can give a family member up to $16,000 interest-free, or at a lower than market interest rate, without needing to file a gift tax return.
This is why it’s good to have a signed contract that defines the terms and expectations of the borrower and lender when taking out a family loan. Without a written agreement, lending money based on a handshake or someone’s word can enter a gray area and become risky.
How To Loan Money to Family
Family loans work best when the terms are put in writing and agreed upon by both parties. You’ll want to include repayment terms and the minimum interest rate in the signed agreement.
Even though a written agreement seems overly formal for a loan between relatives, it protects both parties. A family loan contract allows both the borrower and the lender to communicate the money transfer clearly and legally to the IRS for tax purposes.
To ensure family loans follow IRS guidance, consider the following:
- Consult an attorney: To protect the borrower and lender, it’s a good idea to speak with an attorney about the risks and potential pitfalls of family loans. Families might even consider hiring an attorney to draft the family loan agreement.
- Put terms in writing: Make sure both parties sign the agreement and have it notarized. Include the amount borrowed, interest rate and repayment plan in the contract.
Include the lending party’s recourse in case of nonpayment or forbearance. It’s also a good idea to state whether there’s any penalty for paying off the loan early.
- Charge interest: Follow the applicable federal rate (AFR) established by the IRS for the year the contract begins.
- Agree to a repayment schedule: Make sure the interest rate follows the parameters defined by the loan repayment terms for short-term, mid-term and long-term loans.
- Keep records of payments and track the balance: Give receipts and use a tax accountant if needed.
- Use a safe bank account: Encourage the borrower to keep funds in an FDIC-insured bank account or at a credit union.
- Consider securing the loan with collateral: Define the terms and conditions that initiate the transfer of collateral due to nonpayment. For example, if money is borrowed to buy a car, decide if the car will be used as collateral for the loan if the borrower defaults.
What Are the Tax Implications of a Family Loan?
It’s important to follow specific guidelines when making a family loan, including how much interest to charge (or pay) and what to report to the IRS on a tax return.
With a family loan, the lender pays income tax on the interest earned. The lender must also report any financial losses on their tax return.
If the debt is forgiven, the borrower may need to report the loan forgiveness as income on their tax return.
Pros and Cons of Lending to Family
If you’re asking a family member to lend you money, or if you’re the person lending to family, you’ll want to become familiar with the pros and cons of this financial relationship.
AFRs are lower than traditional loans.
Family loans have short-term, mid-term and long-term payment options. Family loans might provide some level of repayment flexibility during times of hardship.
The family member who initiates the loan can earn money from the interest paid.
The borrower’s lack of credit or poor credit history does not affect the lending decision. A family member is more likely to loan money than a financial institution because they understand the situation.
Family members can help each other out financially.
During times of hardship, the borrower can ask for a loan forbearance until they can resume making payments – without affecting their credit score.
Family members are less likely to loan money using predatory lending practices.
Should the borrower default on the loan, or if the loan terms are unclear, it can strain relationships and cause friction between family members.
The lender and the borrower will need to become familiar with IRS reporting guidelines and requirements.
The borrower does not get the benefit of on-time payments and credit reporting as they would with traditional loans.
Alternatives to Family Loans
Family loans aren’t for everyone. If the potential lender thinks a family loan may strain the relationship, there are alternatives to consider.
The following suggestions can be used as alternatives to family loans:
- Gift the money: A gift can be given to a family member up to $16,000 interest-free. Gifting more than the limit may have some tax implications. Interest-free loans, or those below the standard market rate, are considered gifts by the IRS.
Both parties may want to consult a tax accountant to ensure the gift follows applicable tax laws and is filed correctly on future tax returns.
- Add an authorized user to a credit card: A family member can add a relative as an authorized user to their credit card to help them improve their credit scores.
- Co-sign a loan for a family member: A relative can co-sign a personal loan for a family member to help them build credit; however, remember that a co-signer is on the hook for the loan if the borrower can’t keep up with payments.
- Look into Small Business Association (SBA) loans: If the potential borrower has poor credit but owns a small business, they may be able to get a small business loan through a bank or credit union under their business entity.
Check out crowdfunding, grants and microloans from organizations or charities that help small business owners.
A Helping Hand From the Fam 🤝
It’s great when family members can help each other during tough financial times. A family loan can work out well for relatives who communicate clearly. If you decide a family loan is best for you, remember to put your agreement in writing. Include the repayment terms, interest rate and expectations, so everyone is on the same page.
Willamette Management Associates. “Important Considerations in Intra-Family Loans.” Retrieved June 2022 from https://willamette.com/insights_journal/14/autumn_2014_2.pdf
IRS. “Frequently Asked Questions on Gift Taxes.” Retrieved June 2022 from https://www.irs.gov/businesses/small-businesses-self-employed/frequently-asked-questions-on-gift-taxes
Charles Schwab. “Family Loans: Should You Lend It or Give It Away?” Retrieved June 2022 from https://www.schwab.com/learn/story/family-loans-should-you-lend-it-or-give-it-away