Loans to Family
Ensuring debt doesn’t ruin relationships.
Family should be there to support you and vice versa, but when it comes to real money changing hands that support can get a little dicey. You want to help when you see a family member struggling, but you don’t want to put your own financial stability at risk to do it. You also don’t want that loan to become a wedge that divides you.
Loans between family members certainly can offer advantages in bad situations – you’re hardly going to run a credit check on a sibling who needs cash – but they need to be executed carefully and spelled out ahead of time so everyone is on the same page. While it may be uncomfortable, the more you talk about things like terms and repayment up front, the less likely you are to have conflicts on the other end.
The tips below are designed to help you navigate loans amongst family to minimize conflicts and potential issues with repayment. If you’re struggling financially or have a family member who is, we can help. Call to request a free, confidential debt and budget evaluation from a certified credit counselor. With the right financial solution, you may be able to eliminate the need for a loan entirely.
Step 1: Decide on terms
Loans to family need to be spelled out in detail. Slinging a family member a few hundred bucks with a promise to “pay you soon” is the perfect way to ensure you don’t get paid back and can potentially damage your relationship with that relative. Instead, before you ever hit the ATM or pull out your checkbook, you need to sit down a talk about the loan.
- How much does the family member need, exactly?
- How will they get money to pay you back?
- Will the loan be repaid all at once or will they make payments?
- If it’s being paid on payments, what are the installments and exactly when will they be delivered?
As much as it might be easier to not discuss these topics, doing so is key to keeping a happy family in spite of debts owed. You want to nail down nebulous responses like, “I’ll pay you with my tax refund after April.” Things like this have the potential to cause problems because (1) your relative doesn’t know how much they’re getting back and (2) they may already be promising that money elsewhere.
Step 2: Review your own finances to see if it’s feasible
Once you know the amount they need and how long you’ll have to go without that money, it’s time to go back and review your own budget to see if it’s really reasonable to loan the money.
- First, if you’re taking the money from your regular budget and free cash flow, will it leave you short that month or anytime in the future before it’s repaid? If you’re sacrificing things you need to loan the money, there’s a higher risk of conflict and stress created between the two family members.
- If you’re using savings, do you have that money earmarked for something important? For instance, if the money you loan was supposed to be the down payment on a new car and your current vehicle is barely hanging on, the loan may leave you in a bind.
The old adage, “Don’t loan money you can’t afford to lose,” should be at the forefront of your mind. Ideally, you only want to loan money to a family member if you’ll be perfectly fine if they never pay you back.
Step 3: Decide how serious the loan will be
Depending on the amount needed and the situation, you may consider asking for some kind of security or collateral to ensure you get the money you loan back. You may also decide to charge interest in some cases, particularly on any large sums that the IRS would note in income tax returns that might be considered a gift where you could be taxed for the amount given.
Collateral and security should be discussed upfront and be comparable to the amount of money being loaned. It also shouldn’t leave the borrower in a bad situation where they make their own situation worse just to make you feel more comfortable about giving them money. If you take something for security that’s priceless to that person for sentimental reasons, or something they need to live like a driver’s license or car, you’re setting yourselves up for fights if they deal goes south.
For interest charges, keep in mind that if you charge a family member interest on a loan, you have to claim that as income on your taxes. There are also rules for what the IRS expects to see in the interest rate you charge a family member (yes, the IRS has rules for everything!).
Every month the IRS puts out a table that outlines Applicable Federal Rates (AFRs). These establish interest rates for loans between individual parties – that are, of course, much lower than interest rates obtainable through banks. You can use this information to set a reasonable interest rate on the money borrowed.
For instance, if you gave a family member $5,000 in August 2015 and it’s supposed to be repaid monthly on a mid-term loan, the AFR applied would be 1.56%. All money received from that interest rate being applied would then be claimed on your income taxes.
If you choose not to charge interest, just be careful that the IRS doesn’t consider your “loan” a gift. There are different rules for deductions and tax claims related to gifts than there are for loans. If you get audited and can’t prove the money was a loan, you could find yourself stuck with tax debt and/or penalties to pay; this page on the IRS website has some good information regarding gift taxes.
Step 4: Write it down and sign it
Once you’ve nailed down the terms, any interest rate you want to apply and a detailed repayment schedule, you need to put everything in writing. This can’t be reiterated enough – the written loan is there to protect you and the borrower in case issues arise later. It keeps both parties on the same page when it comes to repayment because there are set terms that were agreed to in advance.
Even if you have to go to small claims court to settle the debt that’s owed because the borrower doesn’t pay, the written loan will make the court appearance easier on you and less stressful on the family as a whole. Just remember, even an open-and-shut court case is still going to cause friction and tension in the family. So if the borrower doesn’t pay, it’s up to you to decide whether you want to pursue the matter or not.
A final note on cosigning
When a family member is struggling and you want to help, you may be tempted to cosign a loan for them instead of loaning the money yourself. However, this is actually the riskier option for your own financial stability rather than just giving them the money outright.
If your family member fails to pay, then you’ll be on the hook the lender – and remember that commercial interest rates are much higher than the AFR you would have charged. You’ll also be faced with all of the penalties tacked on, so you’ll wind up on the hook for significantly more than if you’d just lent the money yourself.
That’s not to say you shouldn’t cosign or should loan money you don’t really have to give just to avoid cosigning, but it’s another important point to consider as you’re weighing options when a family member needs help.