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If you have bad credit or a limited credit history, it can be difficult to get a personal, student, or business loan. If you’ve exhausted traditional loan options, it may be worth turning to family for a loan. But be aware that family loans have both potential advantages and disadvantages.
Although the loan structure for family loans is less formal than a traditional bank loan, you still need to make sure that collateral is in place. There are also potential personal and financial risks for both parties. This can include family tensions if the borrower, you or a family member, defaults.
You can make a family loan agreement a success as long as the lender and the borrower agree to the repayment terms and have a contract in place.
What makes a family loan risky?
Family loans can be risky for several reasons. “Family loans are more or less the last resort for people who urgently need funds,” says Justin Nabity, financial expert and founder and CEO of Physician’s Thrive, a financial planning firm based in Omaha, Nebraska. Those in need of money can seek financial help from loved ones, but ultimately they risk straining family relationships, he says.
One question to consider is whether a borrower cannot repay the money on time. It hurts the lender because he does not have access to these funds. “Family loans will always carry a certain degree of risk depending on the financial situation of the lender and the borrower,” explains Nabity.
How to structure a family loan
To better protect both the lender and the borrower, put a plan on paper. In this way, expectations are set and repayment terms are clearly understood. Answer these questions to make sure everyone understands how the loan is structured:
Are you creating a contract? If so, how?
Most people who engage in family loans tend to advance on the honor system. “They just trust that their loved ones will pay them back on time and as a result they often choose to go ahead without a contract,” says Nabity. However, his advice is “it’s always a good idea to write a contract outlining everything that goes with the loan.”
Make sure the contract includes:
- The amount borrowed
- The repayment schedule, including payment frequency, amounts and a repayment date
- The interest rate that will be charged on the loan (we’ll get to that later)
- What happens if the borrower stops paying
- If there is a penalty for early repayment of the loan
For larger loans, do not use a pre-made agreement. “Get a lawyer to guide you so that it’s a solid deal between the two parties,” Nabity said.
Do you charge interest?
It varies from family to family. “Usually these loans are taken because the banks charge high interest rates, which means the borrower cannot afford bank loans,” says Nabity.
But it’s important not to treat the family loan as a gift. “Think of the loan for what it is: a loan. Talk to the family member and figure out an interest rate that is both affordable for the borrower and fair for the lender, ”he says.
The lender should consider his tax strategy and should know the minimum interest rates for family loans set by the IRS. This is called the applicable federal rate (AFR), which the government sets each month. Minimum rates generally only apply to loans over $ 10,000. If you lend $ 10,000 or less, you are not required to charge interest for tax purposes.
If the loan is larger, the AFR is incredibly low right now. In October 2020, rates ranged from 0.14% for loans of three years or less to 1.14% for loans of more than nine years.
How to define a repayment schedule?
When establishing the repayment schedule, it is important to consider the needs of the borrower. Because this is not a fixed bank loan with a strict repayment plan, there is flexibility.
“This is a family loan. It doesn’t hurt to be slightly more flexible with the loan repayment plan, ”says Nabity. Talk to the borrower, see what their situation is and talk about the length of the loan and the number of payments to be paid, then describe it in the contract.
How do I set the default options?
It is important to make the borrower understand that the money lent is a loan and must be repaid. There are a few options to consider if the borrower defaults, but they are limited, says Nabity.
The lender can describe the legal options in the event of default. “However, in this situation, it’s important to know in advance whether the lender is ready to sue a family member or just absorb the financial loss and move on,” he says.
To avoid default, make sure the borrower has a reliable source of income. Is the loan for a business opportunity a student loan or a car that provides transportation to a job? All of these things should be considered before lending money to the family.
Benefits of family loans
Yes, family loans come with risks, especially for the lender, but they can also be beneficial for both parties. Here are some of the advantages that a family loan has:
- Bad credit may not be a problem. The criteria for granting family loans are quite different from those for other types of loans. Family members usually don’t trust your borrowing history before accepting a loan. If you have poor credit, a family member is likely to be more lenient, despite your credit problems.
- A feeling of goodwill. Helping a loved one through difficult times can be rewarding, especially for the lender. The family member may feel a sense of pride in helping the family by providing financial support.
- Interest rates may be lower. A family member may charge less interest than traditional lenders. This can save the borrower money over the course of a loan. The parent lender has the discretion to choose a lower interest rate.
- Reduced exposure to loan scams. If your parent has poor credit and is in desperate need of money, they may be willing to take more risks to get a loan. If they borrow from you, with a workable structure in place to repay it, that will reduce their risk.
- The lender can charge interest. A family member who charges interest will get a return on the repayment.
- More flexible repayment terms. Because the borrower does not receive money from a bank, there is more flexibility when it comes to repayment. A family member can be a little more forgiving if the repayment is not made on time.
Disadvantages of family loans
Family loans can also carry significant risks. Here are some of the issues that lenders and borrowers might face:
- Family dynamics. Borrowing or lending money from a family member can lead to conflict if the loan is not repaid on the agreed terms. Before lending money to the family, a lender should consider the implications of not getting the money back.
- Your credit rating will not increase. Because family loans are a private matter, even if the borrower repays the loan on time and in full, this favorable history will not be reported to the credit bureaus. A family loan is a lost opportunity to build good creditworthiness.
- It can be difficult to recoup your losses. Lenders may fail to get the money back if a family member defaults. “Since this is an informal arrangement, it is difficult to enforce if the lender wants to recall an overdue debt. In many cases, the courts and the IRS will see it as a gift rather than a loan, ”says Chris Motola, business loan analyst at Merchant Maverick, a product comparison site for small business owners.
- The tax implications can get tricky. When it comes to a family loan, both the lender and the borrower must follow tax laws. Lenders are allowed to charge a fair rate of interest and lenders pay interest on the income earned from the loan. If you charge less than market interest rates, the The IRS may consider your loan as a gift. If this is the case, the lender could be liable for taxes on the gifts.
Alternatives to family loans
Since family loans can lead to discord and other complications, here are some other financial options to consider:
- Donate the funds. If the prospect of entering into a contract is complicated and worrisome, and you are financially able to do so, family members may up to $ 15,000 per person or $ 30,000 for couples, and that won’t trigger the current gift tax laws.
- Co-sign a loan at a bank. Ask a family member if they would consider co-sign a loan. However, the co-signer always takes a risk, because if the borrower is late or in default, the co-signer is responsible for the payment. Otherwise, their credit rating will be affected.
- Check out Small Business Association (SBA) loans. If you are starting or expanding a business, explore SBA Guaranteed Loans, which aims to help entrepreneurs and small business owners. An application process is required, but subscription requirements vary.
- Invite a family member on a line of credit. If you aren’t comfortable becoming a co-signer on a loan, consider adding your parent as an authorized user on your credit card. This can not only help increase your authorized user’s credit score, but you can also potentially earn rewards on their purchases. It is important to have a discussion before adding a parent to any of your credit cards. All costs incurred are the responsibility of the primary cardholder.