Family Loans: Proceed With Caution/ June 20th, 2018
Nothing tugs at your heartstrings like a child's or grandchild's request for help. But what if that request is for a loan?
Your young borrower could pay a lower interest rate on the loan than a conventional lender would charge. And you could earn a better rate on your money than you might otherwise. Everybody could win.
Still, you may wonder whether you're entering into a mutually beneficial business arrangement—or an emotional minefield.
That's why it's critical to ask yourself a few questions before you decide whether to lend the money. And you must be honest—even painfully honest—in coming up with answers.
Can you do without that money?
Ask yourself: If you make the loan and it's not repaid, what will that do to your own financial future?
A financial advisor can help you asses the impact of lending--will you still be financially okay?"
You could lose more than money. An unpaid loan that puts you in financial straits down the road can create family discord.
Are there other options that might be a better fit for both of you? You can suggest that your child or grandchild get a loan from a credit union at an affordable rate, and even offer to help by agreeing to co-sign. That would leave you on the hook for paying the money back, but at least you don't have to front the money.
How reliable is the borrower?
Think like a lender when deciding to help a family member financially. How stable is your child's or grandchild's job situation? Has she shown financial responsibility in the past? Does he have maxed out credit cards or other big debts?
What will an unpaid loan do to your own financial future?
Size up your chances of seeinga good outcome in your family. It all comes back to the reliability of the borrower.
How can you protect yourself?
When you make a family loan, financial advisers recommend creating a written document to formalize the process and remind the borrower that it's a real loan.
Find forms for promissory notes online:
- Internet Legal Research Group
- Rocket Lawyer
- National Family Mortgage (if the loan is for a home)
Have the loan document notarized to give you legal standing. ust realize that having any loan agreement in writing won't guarantee repayment. If the borrower defaults, you'll have to decide how to follow up. Are you really going to take legal action against your child or grandchild?
Should the loan end up in default and you don't pursue legal action, that money will be considered a gift. It's best to view it as such from the start, but don't tell your child or grandchild that.
By keeping the loan amount under the annual gift limit ($14,000 in 2016), if your child or grandchild defaults, you can eventually declare that money as a gift without tax implications for either you or the borrower. If you exceed the limit, you're subject to the gift tax and the recipient must pay income tax on that money.
Charge a minimum interest rate so your loan won't be considered a gift.
If you're lending a large amount, such as for buying a home, consider taking out a life insurance policy on the borrower. That way, if something happens to the borrower or his or her spouse, the loan will get paid off.
What about other family members?
Giving a loan to one child might raise the same expectation in another. But maybe the latter is less responsible. Say "no" when you must and be ready to deal with the repercussions.
Also, prescribe what will happen if you die before the loan term ends. Consider changing your will to show that the person's share of the inheritance is reduced by the amount of the outstanding loan.
That way other heirs won't be hurt financially if the child or grandchild doesn't pay off the loan.
Do you and your spouse agree?
You and your spouse need to agree on whether to lend it at all, and decide what you'll do if the child or grandchild isn't making the expected payments.
Otherwise the situation has the potential to wreak havoc on your marriage, rippling through the entire family dynamic.
Information in this article came from interviews with:
- Neal Van Zutphen, certified financial planner, Tempe, Ariz.
- Jorie Johnson, certified financial planner in Manasquan, N.J.