October 26, 2019 – By Brian O'Connell
When times are tough and money’s tight, you may have limited options of where to turn when you need to get your hands on some cash. If your credit score is great, you may be able to turn to your bank. But remember, you’ll have to pay interest on top of the amount of money you borrow and, in some cases, you may have to pay loan initiation or origination fees. These are fees charged by lenders to process your application. They can be as much as 1% of the amount of the loan.
If this doesn’t seem practical, your credit has you sinking underwater like a rowboat with a hole in it, or if you can’t stomach the idea of going to a financial institution, all isn’t lost. There is another way to get a loan. The quickest path to get your hands on some much-needed money is to go a friend or a family member and ask for a loan.
If you’re on the lending side—that is, if your dear nephew or son-in-law comes asking to borrow money, it can be hard to refuse a family member’s request for a friendly loan. But before you flip out your checkbook, be sure you go into such arrangements with your eyes open and maybe your wallet closed. In this article, we discuss some of the considerations of family loans as well as the potential consequences.
- Treat loans to friends and family as business and keep all your emotions out of it.
- Don’t expect to be paid back but if you do, expect it to be on a slow timeline.
- Make a checklist of questions you need to answer before you open the coffers.
- Consider gifting the money instead of loaning it.
- Don’t keep the loan secret from your spouse.
High Cost of Family Loans
Financing isn’t cheap. Just look around the market and see how much you’ll pay your bank or other financial institution in interest and fees. That’s why many people turn to family and friends. These lenders may be less inclined to charge you anything on top of the amount of money they advance you.
In fact, a survey conducted by Finder showed roughly people borrowed as much as $184 billion annually from friends and family. As many as one in three people surveyed borrowed money from someone they knew, with the average loan amounting to about $3,300.
According to Boston-based American Consumer Credit Counseling, 82% of all Americans would help a family member financially. Younger family members are especially generous, with 92% of individuals aged 18 to 34 saying they would loan cash to a family member in financial distress. As many as 15% of these family lenders never expected to be paid back. Even if the family member knew beforehand that the money wouldn’t be repaid, he or she would provide the loan anyway.
“Americans are turning to friends and family for loans rather than the big banks to avoid spiraling into more debt and defaulting on regular payments,” explained Steve Trumble, CEO of ACCC. “Even though consumer and student loan debts have each surpassed the trillion dollar mark, young Americans are still the most willing to help out friends and relatives in need, which could exacerbate their own debt as well.”
The key to lending money to family members—especially if you expect the money to be repaid—is to treat the deal as a business loan and keep all your emotions out of it.
“By treating loans between family and friends as a business transaction, consumers can safeguard themselves from damaging an important relationship because of money,” Trumble added. “Although you might feel inclined to help out a loved one with finances, it’s important to openly communicate about repayment expectations so that no one is left in the dark, or worse: in the red.”
Before You Lend
Treating a loan to a friend or family member like a business deal is the first way to ensure the process doesn’t ruin great, valuable relationships. Experts advise taking a few steps before you open up your pocketbook and give your financial support to family members.
Keep Your Expectations Low
Don’t expect to get the money back. Go into a family loan situation with the mindset that you’ll never see the money again. That’s not saying you won’t—it’s just that if and when the loan does go un-repaid, you won’t be as disappointed.
“There are no such things as loans among family and friends—they’re gifts,” says Mary C. Kelly, Ph.D., and author of the book “Money Smart.”
“They are a gift if you give or receive them and they are a gift if you get paid back.”
Expect Slow Re-Payment
Kelly says the nature of a family loan—with no professional obligations attached—changes the loan dynamic.
“The reason people need loans from friends and family is that they typically cannot get a loan anywhere else,” she explains. “The financial institution won’t give them a loan or if they do, the interest rate will be too high to be helpful.”
She says people who borrow from family and friends don’t consider these loans as seriously as they do those from banks, so they are far more casual about returning the money. It’s a no-win situation, Kelly notes.
“With close family and friends you, really cannot demand collateral or interest payments and expect to keep a good relationship.”
Make a Checklist
Kevin Murphy, a senior financial consultant at McGraw-Hill Federal, a New Jersey-based credit union, advises putting together a checklist if you plan on lending cash to a family member.
“Sometimes an individual may have no credit history or may have damaged his or her credit so severely that they will need to seek other alternatives,” he says. “A lot of times this member will have no choice but to approach a family member for a loan. I always recommend to friends and the family members to approach this as a business transaction.”
Consequently, if you’re the family member or friend being asked to lend the funds, here is an important list of questions to be answered before you lend:
- Has this person asked me for money in the past?
- If so, was I paid back?
- Was I paid back in a timely manner?
- What is the likelihood that I will be paid back this time?
- What are the funds to be used for?
Another important question you need answers to: How do you plan on paying the loan back?
“This is extremely important because most have good intentions,” Murphy adds. “However, if their income is already accounted for paying all their other obligations, where will your ‘promise’ come in?”
Murphy says having paperwork in place to hold both parties accountable can mitigate many of the problems linked to family loans.
“Just make sure the contract covers the all-important question of payments, particularly what happens if the loan goes unpaid,” he says. “You may need to develop a couple of different repayment contingencies to provide for different scenarios.”
Remember the IRS
You may decide to give up the idea of loaning the money and just consider it as a gift. This makes it much easier to keep your relationship in tact, especially if you never expect your loan to be repaid. But there’s one thing you should be aware of.
When it comes to gifting, you’ll have to remember rules established by Uncle Sam. As of the 2018 tax year going forward, the Internal Revenue Service (IRS) has a $15,000 gift tax rule. A small loan will travel under the radar, but if you don’t charge interest on a loan of that amount or more, it may be considered a gift. Click here for more information.
If you’re married or in a relationship where you’re sharing a bank account with a spouse, make sure that spouse is on board with your decision to lend money to a relative.
“If you lend a family member money, you can cause a strain to your cash reserves, but much more importantly, to your marriage,” Murphy adds. “This is crucial. If approached, make sure you involve your partner right away.”
The Bottom Line
There’s no guarantee a family loan won’t bring disappointment and conflict, but that won’t stop us from helping the people we love the most. If you agree to lend money to family, having a plan is the best thing you can do. Be sure to make sure to set expectations, draw up a contract, and make sure your spouse is aware that the loan is happening.
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