Lending Money to Family – Making It a Win-Win
Some things in life are widely acknowledged bad ideas, like buying Mom another robe at Christmas (have you seen this SNL skit?) or selling an old car to a friend. Lending money to a family member often falls into this category too because if done willy nilly, you could be setting yourself up for lingering bad feelings like disappointment, frustration, or even resentment. On the flip side, if done in the right situation, an intra-family loan can serve as a viable way to create a financial win-win situation.
Here are two short examples where a well-structured loan could make sense. Let’s say you are retired and have a solid cash savings. You have and extra $100,000 in the bank that was paying you a nice 4.0%, but longer-term CD rates are dropping. Your grandson just graduated from college with $100,000 of school loan debt charging an average interest rate of 7%. Your grandson could reduce the interest charges on his school loans and you could increase your savings yield. Or, say your daughter needs $30,000 to buy a used car. Although she qualifies for a car loan, the lender charges her an above-average rate because of her lack of credit history. You know she’s creditworthy, and you want to help lower her costs.
In each of these cases, an intra-family loan can be used to meet the objectives. Here are some tips to increase the chances of a positive outcome:
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Put it in writing. Lending money is a business transaction which should have a written contract or promissory note that outlines the terms of the loan, including the interest rate, monthly payment, schedule of payments, and what happens in case of prepayment or default. You don’t want to think about how this could go sideways, but one needs to recognize that life often throws curveballs. How will things like failure to make payment and premature death be handled?
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Charge an IRS-approved interest rate. We recommend charging an interest rate that at least equals the IRS-approved applicable federal rate (AFR) – currently about 4% to 6% depending on the term of the loan1. It may seem silly, but technically the IRS has rules that state that if you set an interest rate TOO low, some of the interest you collect should be treated as income to you and as a gift to the borrower. Best to avoid that situation.
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Note the collateral. Securing a loan means that the lender gets to take something if the borrower fails to pay as agreed. The collateral should be specified in the contract and is usually something tied to the loan. For example, if the loan is for a car purchase, the lender may take possession of the car and sell it to get their money back. This reduces the risk for the lender and gives the borrower an incentive to pay.
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Keep good records. It’s your job to note payments and keep tabs on principal and interest because the lender needs to claim any interest received as income on their tax return. Other than simply adhering to an amortization table, good records are also important should you later need to write off the loan as bad debt. An informal and undocumented bad debt will be considered a gift by the IRS.
Above all else, don’t compromise a healthy family relationship by the lender-borrower relationship. If there is any chance that the relationship could be irreparably damaged, then you should use traditional lending methods, such as a bank loan.
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Investment advice offered through Great Valley Advisor Group, a Registered Investment Advisor. Great Valley Advisor Group and Haas Financial Group are separate entities. This is not intended to be used as tax or legal advice. Please consult a tax or legal professional for specific information and advice.
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