Family loans: What to know before you borrow or lend within the clan

Multi-generation family at craggy riversideImage: Multi-generation family at craggy riverside

In a Nutshell

Lending between family members can be beneficial to everyone involved. Or it can turn into a nightmare. Before making a family loan, it’s a good idea to learn how taxes can come into play, along with other rules and risks.
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Should I lend money to a family member? It’s a much-debated question.

In fact, the best place to get a loan may be from your family. Loans from family members can be a great deal, particularly for the borrower — but you may have heard the common warning: Never lend money to a family member.

These loans have potential for both financial and personal downsides, as well as possible tax consequences. Here are a few things to know before making a family loan.

What is a family loan?

A family loan, sometimes called an intra-family loan, is a loan between family members. Family loans are often less formal than personal loans from traditional lenders or in the peer-to-peer (P2P) marketplace, which connects potential investors directly to borrowers.

By contrast, family loans may have no contracts or simple contracts where the borrower or lender tracks the interest due and repayment schedules.

Informal family loans may make sense for family dynamics, but a loan is still a contract, and loans have potential tax consequences for both the borrower and the lender: A lender who charges interest will have to pay taxes on any interest earned from the borrower.

If the lender doesn’t charge interest, things become more complicated. The IRS actually requires the lender to pay taxes on “imputed interest charges.” Imputed interest is the estimated amount of interest that the IRS thinks the lender should have charged.

If keeping track of interest, payments and tax implications sounds like a headache, you may be able to pay a peer-to-peer loan administrator to take care of documentation and collect payments for you.

Pros of family loans

  • Rough credit is not an issue: There’s nothing to stop family members from lending to one another, even if the borrower’s credit history is a little banged up.
  • Low interest rates: In some cases, family members lend to other family members at a lower interest rate than a bank would lend to them.
  • Mutual benefits: The borrower may get a loan with better-than-average loan terms, and any interest is paid to a family member instead of a faceless lender.

Cons of family loans

  • Paperwork: When you give a family loan, you may want to create a written contract that includes a promise to repay the loan. This type of contract is called a promissory note. You may also want to track interest owed, payments and more.
  • Tax consequences: When dealing with a family loan, the borrower and lender have to follow tax rules. Lenders may have to pay interest on income earned from the loan, as well as income not earned if they offer a below-market rate. Unless an exception applies, borrowers may have to repay the debt as agreed or claim the canceled debt as income.
  • Family dynamics: Will it ruin Thanksgiving dinner if your brother still owes you the $10,000 he should have repaid by summer? Broken loan agreements can cause family tension.
  • Credit history: Unless they’re reporting your loan payments to the three main credit bureaus, you probably won’t improve your credit history with a loan from a family member.

When should I consider a family loan?

Loans between family members can be risky. Before any money changes hands, think about putting these conditions in place.

  • Loan terms: The borrower and lender ideally should agree on a repayment schedule and an interest rate before making a loan. Loan terms should be put into a signed contract.
  • Legal remedies: If the borrower defaults on the loan, the lender has to decide whether to sue a family member or to absorb the financial loss. If you can’t afford to lose the money, it may not make sense to lend it.
  • Restrictions on use: For example, down payment funds from unsecured loans —including family loans — in some cases aren’t considered valid sources of funding for a mortgage down payment. So if a mortgage down payment is the reason for a family loan, you’ll want to think (and check the details) twice.

Tips to make a family loan legitimate for tax purposes

Although a handshake between family members is an enforceable loan contract, the IRS assumes money transfers between family members are gifts — unless there’s proof that the lender expected to enforce the repayment terms.

Take these steps to help ensure your loan is the real deal in the eyes of the law.

Agree to a repayment schedule

Rules surrounding loans between family members can become complicated if the loan agreement doesn’t include terms of repayment. A best practice for loans between family members is to set a repayment schedule. The borrower could make a payment every month or repay the loan in a few years.

Charge interest

The IRS sets a minimum interest rate called the applicable federal rate.

The applicable federal rate is the minimum interest rate that a lender can charge a borrower for loans over $10,000. If the lender charges less than the applicable federal rate (for a loan over $10,000), the lender will have to pay taxes on forgone interest.

Forgone interest is the interest that a lender would have earned by charging the applicable federal rate, minus any interest actually payable on the loan for the period.

The minimum interest rate varies based on whether a loan is a short term (three years or less), midterm (over three years but not over nine years) or long term (over nine years) loan.

As of January 2021, the annual applicable federal rate for a short-term loan was 0.14%. A lender who doesn’t charge at least the applicable federal rate may have to pay taxes on the unearned interest.

Put it in writing

While a handshake technically is an enforceable loan contract, putting the repayment terms in writing gives you something concrete showing there’s an expectation that the lender will enforce the debt repayment terms.

Keep records

The paperwork doesn’t stop after the loan is issued. The borrower and the lender should record payments and keep track of the balance of the loan. Good recordkeeping will help with taxes and will help keep family members on the same page.

Tax rules around gifts and loans can be complicated. If you’re unsure of the tax implications of making a family loan, it may be worthwhile to consult a tax professional.

Alternatives to family loans

When money and family mix, relationship dynamics can get messy. Here are a few alternatives to consider if you don’t think a family loan is right for you.

Give a gift

If you’ve got the financial means, you may want to consider giving money to family members with no strings attached. For 2019, family members can give up to $15,000 per individual giftee without triggering gift tax laws.

Use a personal loan

If a family member can’t afford to lend to you, you may have better luck finding a personal loan. In some cases, a family member may be willing to co-sign the loan. When a family member co-signs the loan, that person agrees to become responsible for the payments if the borrower defaults.

Remember, both the borrower’s and the co-signer’s credit is on the line if the borrower is late making payments.

Consider a business loan

If you’re trying to start a new business or grow a side business into a full-time occupation, a business loan may make more sense than borrowing from friends or family.

Entrepreneurs can consider a variety of loan options when starting a business. Some popular funding choices for small-business owners include business credit cards, microloans (loans typically under $50,000) backed by the Small Business Administration, an SBA-guaranteed loan from a bank or community development organization, or a traditional business loan from a bank or peer-to-peer lender. 

Make a family member an authorized user

Not willing to co-sign a loan or lend a family member money? You may still be able to help them boost their credit scores by making them an authorized user on your credit card.

When a credit card holder adds someone as an authorized user, the bank may report the primary credit card holder’s information on the authorized user’s credit reports. If the primary cardholder has a great credit history, the new authorized user could see a boost to their credit scores. Better credit scores could help the authorized user become eligible for a loan from a lender. 

Bottom line

A family loan ideally creates a win-win situation for the borrower and the lender. But if the family loan goes sideways, it may hurt your relationships, if not your credit scores.

Before borrowing from or lending to family members, think through all of the possible consequences. If the loan still makes sense for both parties, be sure everyone is on the same page by putting the loan in writing and carefully tracking the repayments.

About the author: Hannah Rounds is a freelance writer who covers consumer finance, economics, investing, health and fitness. She received her bachelor’s degree in economics from Furman University. Read more.