If you must lend money to a family member, get the deal in writing
The idea of lending money to a family member is about as welcome as receiving an appliance from your loved one for Valentine’s Day. It’s generally thought of as a bad idea. However, in the right situation an intra-family loan can serve as a viable alternative to traditional savings and lending vehicles that results in a win-win for the lender and the borrower.
Let’s say you are retired and living off a fixed income. You have $100,000 in bank deposits yielding .10 percent. Your son just graduated from college with $25,000 of school loan debt charging an average interest rate of 6 percent. You would like to increase the yield on your bank deposits, while your son would like to reduce the interest charges on the school loans.
Or, say your son needs $10,000 to buy a used car. Although he qualifies for a car loan, the lender charges him an above-average rate because of his lack of credit history. You know he’s credit worthy, so you want to help him lower his costs while getting more yield on your bank deposits.
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:
Put it in writing – Lending money by its nature is a business transaction and should be founded on a true creditor-debtor relationship. A written contract or promissory note should be executed that outlines the terms of the loan, i.e. the interest rate, monthly payment, schedule of payments, and what happens in case of prepayment or default. Also, an informal loan may have unpleasant consequences if the lender dies. Suppose you lend $25,000 to your son, but you die before he repays the loan. Your daughter may be unhappy if that $25,000 is not deducted from your son’s share of your estate.
Charge an IRS-approved interest rate – Although you can set your own interest rate, you should charge an interest rate that at least equals the IRS-approved applicable federal rate (AFR) – currently around 1 percent to 4 percent depending on the term of the loan. Under complicated IRS rules, below-market-rate loans require the imputing of interest that will be treated as income to you and as a gift to the borrower.
Secure the loan – This 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 have the right to take possession of the car and sell it to get their money back. Secured loans reduce risk for the lender and give the borrower an incentive to pay.
Create a solid paper trail – Once the loan is made, you should maintain records of all payments and any demands for repayments if the borrower falls behind. The lender should also record any interest received as income on their tax return. This information is important should you later need to write off an intra-family loan as bad debt. An informal and undocumented bad debt will be considered a gift by the IRS.
Above all else, a healthy family relationship should not be compromised by the lender-borrower relationship. If there is any chance that the relationship could be irreparably damaged, then you should resort to traditional lending methods.
Dan Mathews is a Wealth Manager with Creative Planning Inc. He works directly with clients to develop and implement a strategy to address their financial, investment, tax and estate planning needs. Dan is currently one of a select group of CFP Board Ambassadors throughout the country, whose mission is to provide personal finance resources to the community, policymakers and local media. Outside of the office, Dan serves on the stewardship team at his church. He enjoys boating, fishing and spending time with his wife and three children.
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This story was originally published February 23, 2017 at 11:00 AM with the headline "If you must lend money to a family member, get the deal in writing."