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Family loans: How to dodge the drama with your loved ones

Borrowing from relatives can be a risky option and uncomfortable for borrower and lender.

Before lending money to a family member, consider

Before lending money to a family member, consider the pros and cons. Photo Credit: Getty Images/iStockphoto / juankphoto

Financial advisers don’t always agree, but when it comes to lending money to family, there’s consensus: Tread carefully.

If an adult child needs help buying a first home or has a promising business idea, a family loan can be a fast and convenient option. But there’s a risk of drama down the road.

Here are tips for lending and borrowing money among relatives.

  • Pros and cons. There are advantages for a borrower: no credit check, low or no interest and flexible payback terms.

It can also be a way to help young adults learn about financial responsibility, says Walter Pressey, a retired financial industry executive in Boston who loaned money to two of his children with LoanKin, a loan servicing website.

But loans can be uncomfortable for the giver and receiver. If you’re the family ATM, you may have trouble saying “no” and thus jeopardize your own finances. If you’re the one asking family for money, you may feel a sense of obligation over payments that strains the relationship.

There are also tax considerations. Charge zero interest, and you may face a gift tax, and the borrower may have to report the gift as taxable income. Tack on interest and you must report it as income.

  • Exhaust other options first. These include a personal loan from a bank, credit union or online lender. The latter two sources typically have more flexible qualification requirements than a bank. Taking a personal loan co-signed by a family member may require more disciplined payback than borrowing directly from the relative, and paying it back can build your credit score. But not repaying a co-signed loan can ruin the lender’s credit and your own, and he or she will have to repay it if you cannot.
  • Assess the reason. If you are lender, try to set your emotions aside and look at the reason for the loan. Has your family member been rejected by banks and other lenders? If so, why? Will your loan help promote good financial decisions?

“Good” reasons for a loan could include buying a house or starting a business. “Bad” reasons could be paying credit card or gambling debt, says Eric Gabor, a financial planner at Eagle Grove Advisors in New Jersey.

When Pressey’s daughter shared her worry about her credit card balance, he offered her a loan to pay off the debt and pay him back at a lower rate. Second, he taught her to pay off each month’s credit balance in full.

  • Spell out terms. Avoid problems by using a family loan agreement, says Derek Tharp, a financial planner at Conscious Capital in Cedar Rapids, Iowa. Signing a promissory note with the family members involved and getting it notarized may seem impersonal, but it can prevent hurt feelings and disputes.

The lender must clearly spell out the loan terms, says Charley Moore, founder and CEO of Rocket Lawyer, a website that provides templates for legal documents. That includes defining when the loan should be repaid, whether it’s due in fixed installments or a lump sum, and what happens if the borrower has trouble with repayments.

Before loaning money, financial planners recommend considering the impact on your own goals, such as retirement. And while loved ones might have every intention of paying you back, be sure you can afford to part with the money if things go south, experts say.

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