By Vera Wilson
brother lost his job and his wife is eight months pregnant, so he asks
you for a short-term loan to tide him over. Or maybe your best friend
wants to borrow some money to launch that decorating business she's been
dreaming about for years. You have the funds, but when - if ever -
should you loan money to family or friends?
Your money - or your relationship?
said it best: “Neither a borrower nor a lender be; for oft loan loses
both itself and friend.” Late payments or a loan that's never fully paid
back can strain or even destroy a relationship. You might feel it's
impossible to say no if you want to preserve the relationship. But don't
let them take advantage of your good nature. If you fear mixing
business with pleasure will prove destructive, then say so. Offer
alternative support, such as giving a smaller amount of money as a gift
or offering to drive your friend to work until he can afford that new
As good as gone
Never loan money
you can't afford to lose. A CNN Money survey suggested over a quarter of
loans made to family and friends were never paid back and less than
half were paid back in full. Ask yourself: “If the money isn't repaid,
what will that do to my financial position?” Like any creditor, you may
pursue collection activities like suing the borrower or placing a
judgment or property lien against him to recoup the money. That might
mean dragging your own cousin to small claims court - something many
relatives aren't willing to do.
Consider the circumstances
smart to ask the borrower why they need the money. Emergencies arise,
and you might be providing your loved one with the lifeline they need to
save their house or cover skyrocketing medical bills. But what if
they're just lived beyond their means and want to borrow from you to pay
off other mounting debt? Has the bank turned them down because of bad
credit risk? If so, maybe you should to turn them down, too.
merit a special mention. They represent the most common intra-family
loans, as adult children, excited to buy their first home, might not
have enough credit history to satisfy a traditional lender. In turn, a
loan can prove profitable for parents because the interest earned is
likely to be more than with conventional financial instruments like
bonds and CDs, making it a win-win. Using a service like National Family Mortgage, which helps structure the loan and handle all the paperwork and reporting, keeps the process simple and professional.
A handshake is not enough
you've decided to make the loan, shake on it, but then insist on
putting the loan agreement in writing. This prevents any
misunderstandings and protects your legal and tax standing. This
promissory note should state the type of loan (secured or unsecured),
interest rate, payment amounts and schedule, as well as any penalties
and collateral, if applicable. It should be signed and notarized by both
parties. Loan-agreement templates are available on websites like www.nolo.com, or consult your attorney.
Burden of proof
Internal Revenue Service (IRS) treats loans very differently from
monetary gifts. A loan without interest or never paid back might be
considered a gift, which can lead to negative tax implications for the
lender. To avoid this possibility, charge interest equal to or greater
than the applicable federal rate, which is published monthly on the IRS.gov.
Current rates range from 0.65 percent for short-term loans to 3 percent
for long-term loans. Loan amounts affect the rate as well.
documenting the loan and your attempts to collect it are crucial if you
want to claim a bad debt on your tax return and avoid having the money
categorized as a gift, in which case you could pay taxes on anything
over the current $14,000 exclusion.
If all goes smoothly with the loan, the borrower will need to report all interest paid to you annually on Form 1099, which you'll need to claim as interest income on your tax return.
Offering money, not advice or a free pass
and family who have successful loan arrangements make communication a
priority. Encourage the borrower to let you know if they'll be late or
can't pay and consider a more lenient payment plan to keep the loan on
track. Lenders also should realize loaning money doesn't give them the
right to micromanage the borrower's finances; resist the urge to
question their spending habits or offer unsolicited financial advice.