Loan Agreements With Family And Friends

Loan Agreements with Friends and FamilyMoney is a funny thing when it passes between family and friends, especially if you are the one borrowing from or lending to a member of your family or a close friend.

According to the Federal Reserve Board Survey of Consumer Finances, loans from family and friends amount to $89 billion each year in the United States. The most popular reasons for asking family members or friends for a loan are to start a business or purchase a home. A national survey by Fundable said that 38% of startup businesses relied on money from family or friends. The National Association of Realtor said that 6% of first-time home buyers used money from family, mostly parents, to buy a house.

Another good reason for seeking a loan from loved ones is when a family member becomes unexpectedly unemployed or is hit with a sudden illness. Other popular reasons include buying a car, a computer or other technical equipment or something more personal like an engagement ring or to pay for a family vacation.

How To Borrow From Friends Or Family

The main advantage of receiving a loan from a friend or family member is that your “lender” is more likely to be flexible about payment arrangements. Also, when you borrow from a loved one, you often can borrow 100% of the required amount and enjoy lower interest rates (or no interest at all). The most unfortunate part of borrowing from someone you know is that your personal relationship could be damaged permanently if the situation goes south.

Treat a personal loan issued by a loved one with the same respect and professionalism as you would a loan from a bank. If you plan to borrow money from a bank, credit union or other lending institution, you already know you must be prepared to sign a legal contract outlining your obligations to the lender: On time payments until the loan is paid in full. This contract is called a promissory note.

Should it be any different if you borrow money from friends or family? Not really. Even though they may have known you for years or even a lifetime, they still need assurance that you’ll pay them back as promised. The fact you know them really well doesn’t remove any of the obligations and responsibilities associated with taking on a loan.

It is a wise move to draw up and sign a loan contract regardless of your relationship with the lender. This protects both parties in case of a disagreement. A loan agreement between two individuals is more simplistic but very similar to a standard bank promissory note.

Basic terms for a loan agreement with family or friends should include:
  • The amount borrowed (principal)
  • Interest rate (if applicable)
  • Repayment terms (monthly installments over a set period of time or a lump sum on a certain date)

One of the most important things to address in a loan contract with a friend or family member is what will happen if you can’t pay?

The loan agreement should clearly state the lending party’s recourse in case of nonpayment, including:
  • Adding additional costs to the loan
  • Modifying the loan terms
  • Taking ownership of collateral
  • Pursuing legal action

What Happens When You Default?

Like any loan contract, you’re legally on the hook for the debt. If you fail to abide by the terms of the agreement, your lender — in this case, your loved one — can take legal action against you. With the contract as proof, the lending party can sue in small claims court, get a judgment and then pursue collection activities on the loan — such as wage garnishment or property liens — just like other creditors. If you cannot negotiate more reasonable loan terms privately, a lawyer might be able to either negotiate on your behalf to include part of the balance due in a debt settlement agreement or add it to a debt consolidation loan. It is important to take action before a judgment is entered in small claims court because the lending party can often pursue your personal assets, bank accounts and wages.

Preserving The Personal Relationship

Everyone has ups-and-downs with their finances, but things get really uncomfortable when you take family or friends on a roller-coaster ride when repaying a loan. Relationships built over years or even decades, crumble when conditions of a loan agreement are ignored or broken.

If you fall behind on a loan from a loved one, it is important to keep the lines of communication open. Good communication is the best way to avoid animosity with family and friends who have loaned you money. Like it or not, a person lending money feels like it’s an investment. They want to know how the project or business is doing and whether this loan is going to be paid off.

That is why it’s so important to have everything about the loan down on paper. It’s easy to reach a verbal understanding with family and friends, but difficult to remember the details a year later. Write it all down and make sure both sides understand the details of the agreement.

A borrower should consider giving lenders periodic updates (monthly, quarterly or annually) to discuss the project or business. It helps to know in advance that there may be problems paying the loan and if there are alternative relief options
while the problem is resolved.

Finally, both sides should anticipate there will be trouble spots and decide ahead of time how they will respond. Emotions run high when both sides appear to be losing money. There isn’t much to be gained getting into a heated argument with family or friends over debt.

Both sides should be realistic about what is expected. The borrower should make repaying the loan a top priority. The lender should expect some problems. That is usually why they were asked for the loan in the first place.

What To Do If You’re The Lender

The lender has the most to lose, literally and figuratively, in situations where there is a loan agreement with family or friends. The lender not only puts his money at risk, he puts his reputation and relationship in danger, too. He could lose it all – money, family and friendships – if things go wrong and he stands to gain little more than a few dollars of interest if everything goes right.

That is why people must think long and hard before loaning money to family or friends. It can be a costly exercise.

Here are a few things, some very stark, to consider before making the loan:
  • What is your family’s net worth and can you afford to tie up your money for whatever time period is suggested?
  • Would you be willing to foreclose on the borrower or sue if they default on the loan?
  • Would you impose penalties for late payments?
  • Would you get involved in the project or business to help get your money back?
  • Have all other options been exhausted: Banks, credit unions, other family members.
  • If lending institutions won’t give them money, do you really want to take on the risk?

If you have examined all the negative outcomes associated with making a loan and decide to go through with it, here are a few steps that might help toward a positive outcome.

  • Ask for a plan. The borrower should furnish details of what the money will be used for, the schedule for repayment and what will happen if he defaults on the loan.
  • Review the borrower’s finances and help them set up a budget that includes your monthly repayment.
  • Make sure they understand this is a loan, not a gift.
  • Set terms that both sides agree can be enforced … and enforce them!
  • Keep your distance. Just because you give someone a loan, doesn’t mean you can meddle in the project or business.
  • Get it down on paper. It’s easier to settle arguments when everything is written down – and signed!

Tax Implications of a Family Loan

According to the Federal Reserve Board Survey of Consumer Finances, loans from family and friends amount to $89 billion each year in the United States. The most popular reasons for asking family members or friends for a loan are to start a business or purchase a home. A national survey by Fundable said that 38% of startup businesses relied on money from family or friends. The National Association of Realtor said that 6% of first-time home buyers used money from family, mostly parents, to buy a house.

Dealing with the IRS is one of the critical, but often overlooked aspects of loans between family members or friends. Both borrower and lender have responsibilities, though most of them fall on the person lending the money.

The first thing the IRS wants is clear proof that this is a loan and not a gift. That means charging, and collecting interest under the IRS rules for applicable federal rate. The minimum rate in October 2014 was 0.38% for loans of less than 3 years, and 1.85% for loans of 3 to 9 years.

If the parties involved are not paying and collecting at least that much in interest, the IRS could deem the money a “gift” and apply gift taxes, depending on the amount.

The next step is to draw up legal documents for the loan. If the loan is for a home, that includes a deed of trust and recording the loan with the county.

The two sides must sign a promissory note that spells out the interest rate, terms and conditions, length of repayment period and ability to transfer the loan to another party.

There also should be an amortization table that shows the amount of principal and interest paid and the balance due after each month for the lifetime of the loan.

The lender must file IRS form 1098 stating how much interest the borrower paid over the course of each year. The lender also must file IRS form 1099, which states how much interest he received on the loan and report that amount on their tax return. This is an essential step in the loan process as there are severe tax consequences if any of these steps are missed.

Alternatives To Loans From Family Member

A 2009 survey by CNN Money reported that 27% of people who lent money to family or friends didn’t receive any money back and 43% were not paid in full. In other words, most of the time loans between family and friends don’t work and destroy relationships.

However, there are alternative sources of money if you want to avoid the very real possibility that taking or giving a loan to a family member or friend will not result in a good outcome.

Admittedly, it will be difficult to tap some of the sources for mortgage loans, house renovations or car loans, but if you’re looking to start a business, the Small Business Administration is a government agency dedicated to serving small businesses. They offer a variety of loan programs, including a General Business Loan that could get you $50,000 to $250,000. The SBA also has a Microloan program that offers up to $50,000 for startups and some non-profit childcare centers.

When you go online, there are peer-to-peer lending sites such Lending Club and Prosper or crowdfunding sites like Kickstarter and Crowdfunder may deliver the loan you don’t want to ask Mom and Dad for.

If you’re looking for something that will help with a renovation or be a down payment for a home or new car, you could consider borrowing from your 401(k) retirement fund or doing a home equity loan or home equity line of credit (HELOC).

Bill Fay

Bill Fay is a journalism veteran with a nearly four-decade career in reporting and writing for daily newspapers, magazines and public officials. His focus at Debt.org is on frugal living, veterans' finances, retirement and tax advice. Bill can be reached at bfay@debt.org.

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