A situation we see here at White Oaks often is our clients want to help family. One way to do this is by a family loan. Whether to a parent, a sibling or a child, our clients often feel an altruistic pull to help family out by lending them money. This can often be a great situation for all involved – the lender can help the borrower, whom, they presumably love and the borrower’s interest goes back into the family, rather than a bank or other institution. Furthermore, the borrower does not have to submit to more rigorous underwriting and often the funds are immediately accessible.
Before lending to a family member, though, there are some things to consider.
First, is this a loan or a gift? Making the distinction matters. Gifting means the lender has no intention of receiving the money back. A loan is repaid. Make sure both parties are clear if this is, indeed, a loan rather than a gift.
As a loan, you will need to set up parameters. Here are some helpful questions to address:
- How often will the payments occur and in what form?
- Will interest be charged?
- If the borrower does not pay the loan back in a timely fashion will there be collateral taken or late charges assessed?
- What happens if the borrower cannot pay due to injury or illness?
- If the lender passes prematurely, does the loan effect the inheritance, if any?
- Is there realistically enough income on the borrower’s part to repay the note?
- For large purchases, like a home or auto, will the lender put a lien on the collateral?
Make sure that you address the logistical details, even the minor ones, at the outset. This will clarify and refine expectations of each party. Once you have the details sorted out, we recommend getting an attorney to draft a document that will be signed and notarized. Give each person a copy of the agreement.
One of the benefits of an intra-family loan is that the lender can charge low rates of interest, if desired. Make sure, however, that the rates aren’t too low or the IRS could consider the non-paid interest as a gift. Look to the IRS’s applicable federal rates for guidance on where to start in establishing a fair interest rate.
Once you’ve decided upon an interest rate, it is helpful to have an amortization schedule drawn up, too, to know where the loan stands at any time. An amortization schedule simply shows what amount has been paid, what remains, and what each future payment date is.
By taking the necessary steps at the outset to ensure each party is on the same page an intra-family loan can be a wonderful tool to help family members.