Family loans remain one of the most contentious types of debt in the modern world. Borrowing from other family members can often provide you with a source of cash that no one else will offer you. This can be an invaluable benefit for struggling entrepreneurs, young people who need to make major purchases, or homebuyers that cannot manage their current debt level without some extra help. But family love and financial debts do not easily fit in the same space: It is no surprise that family loans are filled with risk and often lead to feuds and damaged relationships regarding the borrowed money. Here are six tips to making this difficult form of loan work out.
1. Borrow (and Lend) Only What is Possible:
Family loans tend to progress more smoothly when both sides understand their limitations. Borrowers should only ask for amounts that they know they can pay back plus interest. Lenders should only offer money that they can give up without sacrificing any quality of life or future financial activity. This helps limit what is at risk during the transaction and makes it easier to put emotions on hold when dealing with loan problems. Taking a long, hard look at finances before agreeing to any loan is a necessary first step.
2. Consult an Attorney:
An attorney can be an excellent third party, offering a clear perspective removed from family affairs. If both parties are willing to add the expense of a legal consultation, this can help families find out the best legal way to lend money and the most effective form of loan to consider. Attorneys will also help families pinpoint all the caveats, like what to do if a family member dies, or the loan goes into default, or if unexpected debts arise. Lawyers may be able to draw up contracts for family members as well.
3. Use a Promissory Note:
A Promissory Note or similar instrument can be used to fashion a loan contract between two family members. This is a legal contract where one party agrees to pay another party a certain amount of money by a certain amount of time. Promissory Notes and their ilk can also include key terms like interest rates, penalties for late payments, and actions in case of default. These notes help outline what is clearly expected, and bring in the law for faulty behavior, skipping the “poor excuses” stage.
4. Understand IRS Regulations:
The IRS understands that family members may want to create loans for each other, but they also do not want people to dodge taxes but creating a complicated loan system to hide their earnings. For this reason, the IRS requires that family loans have a minimal interest rate similar to that of the traditional loan market. The absence of an interest rate or an extra-low rate makes the loan count as a gift and requires the dreaded gift tax. So an interest rate is typically a necessity for family loans: More detailed regulations can be found on the IRS website.
5. Keep in Constant Contact:
Family loans work better with contact. Both parties should communicate frequently and honestly about the loan. How is the money being used? Are the terms easy to meet? Will there be any trouble in meeting the next monthly payment? Answering these questions can help families stop financial problems before they even start.
6. Prepare for the Worst:
This sounds negative, but family loans have some of the highest risk around. People typically borrow from their families because they cannot get loans anywhere else, putting them in the riskiest category of borrowers. This gives family loans a very large probability of going into default or at least running into late payment problems. These problems should be expected, due to the nature of the loan.