When the economy isn't cooperating, many people find themselves short on cash. This can happen to loved ones too. Those that are more fortunate are sometimes faced with the decision whether or not to lend money to a friend or family member.
In this article, we're going to talk about the thought process, and the questions to ask, before lending money to family or friends. As part of that discussion, we'll also talk about how to structure the loan, as well as the tax implications of lending someone money.
Lending Money
Making a decision to lend someone money should only be done after thoughtful reflection. It's important to really understand why the money is needed. It's equally important to understand if it's a financially sound decision.
Family and friends that are in need of a loan typically fall into one of two broad categories:
Individuals that have temporarily fallen on hard times, and are in need of a loan until they are back on their feet again. For example, the loss of a job can sometimes trigger the need until a new job is found.
Individuals that are behaving irresponsibly when it comes to spending habits, living a lifestyle that is bigger than they can really afford.
Of course there can be many variations on the above two themes, and that's why it's important to ask questions. Before committing to a loan, the lender has a right to know:
Why is a loan needed?
Why isn't the borrower applying for a personal loan from a more traditional lending institution?
How is the money going to be used?
How much money is needed?
How long will it take to repay the loan?
It's also important for the lender to understand if they can afford to give a friend or family member money. Even if the borrower has very good reasons for needing a short term loan, the lender should never jeopardize their own financial security.
Structuring Agreements with Family and Friends
Lending money is not the same as giving someone the gift of money. Gifts are not expected to be repaid. Loans are repaid and the approach to structuring the agreement should be business-like, so there are no misunderstandings later on. The rate of interest charged should be known, and the terms and conditions should be spelled out using a simple promissory note.
Interest Rates
Typically, lenders are not looking for a windfall financial gain at the expense of a loved one that has fallen on hard times. The interest rate charged should be less than that charged by a more traditional lender. Therefore, determining a fair rate of interest will require some research.
The interest rate also needs to be higher than what is called the Applicable Federal Rate, or AFR. These rates are published each month by the IRS, and are divided into three categories:
Short-term: an average of U.S. Treasury securities with maturities less than three years.
Mid-term: an average of U.S. Treasury securities with maturities between three and nine years.
Long-term: an average of U.S. Treasury securities with maturities greater than nine years.
If the interest rate on the loan is less than the AFR, the loan can be considered a gift and trigger a taxable event on a federal income tax return. The following is a link to the most recent Applicable Federal Rates.
Promissory Notes
Even when lending money to family members, the transaction should be treated like it was a business arrangement. Promissory notes can be used to detail the terms and conditions of the agreement, and will contain the following elements:
Promise to repay
Total amount borrowed
Interest rate charged on the outstanding balance
Installment amounts, frequency of repayment, first payment date
Late payment fees
Successor clause
Signatures / notary witness
There are numerous examples of promissory notes that can be found on the Internet and downloaded for free. This includes templates that can be used with applications such as Microsoft's Word. Discussing the terms and conditions of the loan, and preparing a written contract, will help to prevent any misunderstandings later on.
Risking Relationships
The long term consequences of lending money to a friend or family member can be good or bad. It's a great feeling to know someone can be counted on to help when hardships strike home. Unfortunately, money matters have also been known to tear families apart.
Misunderstandings can be kept to a minimum by openly communicating when an issue arises. It's better to have a tough conversation with someone than to let bad feelings build. Finally, be prepared in the event the money is never paid back. Know ahead of time how to react, including if it's better to lose a good friend or an investment.
Additional Resources
- There are a number of advantages debt consolidation loans have to offer, but the commitment is significant. By taking a variety of debt and consolidating it, the risk associated with default on each of the individual loans is now in one place.
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