Should you lend a friend or family member money? Should you ask a friend or family member for a loan? These can be difficult questions and they don’t always have an easy answer.
Of course, if you have someone in your family or friend circle that needs money and is struggling, the natural inclination is often to help them out. However, there are considerations to make when lending or borrowing from someone close to you.
This article gives you an overview of what these loans look like, what the pros and cons are, and items to include in a personal loan agreement with friends or family.
What Do Personal Loans Between Friends and Family Entail?
These types of loans are often informal when compared with other types of loans from traditional lenders. In some cases, the lender and borrower may not want to have a contract—which may not be the best idea—or the contract will be simple and will have a low interest rate.
It’s important to remember that there are still potential tax consequences that need to be considered for the borrower and the lender with personal loans.
There are both pros and cons to partaking in loans between family or friends. Not only can there be financial issues that arise, but if there’s a conflict, it could also cause personal issues between the lender and the borrower. That’s one reason why a lot of people are opposed to lending money to family members and friends.
Still, these types of loans have quite a few benefits, especially when compared with other options people may or may not have access to. Let’s take a closer look at the pros and cons before you decide whether lending or borrowing from friends or family is a good idea.
The Pros of Friend and Family Loans
Here are four different positive aspects of entering into a loan agreement with a friend or family member.
1. No Credit Check
One of the main reasons people turn to family and friend loans is because they are unable to get loans using other methods. This is often due to credit problems that they have had in the past.
There is nothing that will prevent a friend or a family member from providing money because there isn’t going to be a credit check. Even if the borrower has troubled credit, they could still get a loan from someone they know.
2. Lower Interest Rates
It’s often cheaper to get a loan from a friend or family member, as well. While they may charge interest on the loan, as the IRS requests so they can tax it, the interest rates will generally be lower than what someone would get through a personal loan or with their credit cards.
This will, in turn, help the borrower save quite a bit of money when they are repaying the loan.
3. Faster Approval Process
One of the other benefits is that it tends to be faster than other types of loans. Rather than waiting days or longer to see whether the loan is approved, the borrower will be able to get money right away. It is often a matter of making a simple transfer or trip to the bank.
4. Late Payments Will Not Affect Credit
If the borrower is late on a payment with these loans, it’s not good. However, it won’t have the same types of consequences that being late with a traditional borrower will have. Namely, it will not hurt their credit score if they are a few days late.
It could hurt the relationship with the friend or family member that lent the money, though. If there is a month where the payment will be a day or two later, it’s always important to keep the lender in the loop.
The Cons of Friend and Family Loans
Just as there are benefits, there are also potential cons. Here are the top two most common negative aspects of a friend or family loan.
1. Positive Payment History is Not Reported
Traditional personal loans are a great way to build your credit. If you have a good history of on-time payments, you can expect your score to steadily rise.
When you are borrowing from someone you know, they aren’t reporting to the three credit bureaus. This means that even though you are making regular payments and showing that you are responsible, it will not do anything to improve your credit history and score.
2. Issues With Friend or Family Dynamics
As was touched on above, you have to be careful about the issues it could cause with your family dynamics. If the borrower is not on time with their payments, it can make get-togethers and holidays awkward for everyone.
If the lender is always asking the borrower about when they’ll be paying, even though they’ve always been on time, it will cause problems, as well.
You know your family and friends better than anyone else. You have to be the one to decide whether it’s a good idea to borrow from them or not. If you do, you’ll want to make sure that you have a written personal loan agreement, which will help to reduce any potential issues that could arise.
The Tax Consequences of Friend and Family Loans
While small loans of a few hundred dollars are not likely to cause any issues, large loans for major purchases or to help someone get their business off the ground could have tax consequences.
Therefore, you will want to agree to a repayment schedule, and the lender will need to charge interest. The IRS has a minimum interest rate called the applicable federal rate (AFR), which applies to loans over $10,000. If the lender doesn’t charge that amount in interest, they will have to pay taxes on the “foregone interest.”
Foregone interest is the interest that the lender would have gained if they had charged the applicable federal rate. The interest rate will vary based on the length of the loan. A short-term loan is considered three years or less, while a midterm loan is considered from three years up to nine. Long-term loans are those over nine years.
Always make sure that you understand the latest tax laws and the interest rate that needs to be charged on the loan before writing out an agreement.
Writing a Friend or Family Personal Loan Agreement: What You Need to Know
If you are lending a smaller amount of money, you should still have a personal loan agreement. It is one of the best ways to ensure that everyone is protected and feels comfortable lending and borrowing money. You can create one of these simple documents in six easy steps.
Step 1: Beginning the Document
The first step is the easiest, but it’s one that you can’t forget. Write the date at the top of the page. If you are creating the agreement before you receive the money from the loan, you will fill in the date when you receive the money.
Step 2: Write the Terms of the Loan
Next, you will write out the terms of the loan. This will state the purpose of the personal payment agreement and the terms for returning the money.
Let’s say that you need to borrow $1,000 to repair your vehicle and you will be paying back $100 a week to the lender. You could write the following:
“I ______, understand and agree that I owe ______ $1,000. I agree to pay $100 a week until the loan has been repaid in full.”
Fill in the correct names in the blank spaces. If there is interest being charged, this will also go into the terms of the loan and will be calculated in the overall amount that’s owed.
It is important to be as clear as possible when writing the terms of the loan. You need to be sure that both parties understand and agree to all of the terms that are in the paperwork. This may include what will happen if the payments are not made.
Step 3: Date the Document
Don’t forget to add the dates to the document. Make sure the date on which the payments are supposed to begin is clear for the start and finish date for repaying the money. This is simple enough to do.
You could write something like “Repayment will begin on the first Friday of December 2021 and will be completed on the last Friday of January 2022.”
Step 4: Statement of Agreement
This is a simple line that could read “The lender and borrower agree to the above-listed terms”. It should be a few lines below the repayment schedule. This line is simply to show that both of the people agree to the terms in the agreement.
Step 5: Signatures
If there are no signatures on the document, it will be difficult to enforce in the event that you have to go to court. While no one wants that to happen, it can and it does.
Therefore, make sure that all of the parties involved who are responsible for lending or borrowing sign the agreement. Be sure there is enough space for all of the signatures when creating the document.
Step 6: Record the Document
Step six is where many people make mistakes. They simply make a copy of the agreement for themselves and the other party and call it a day. However, you should go to the county recorder’s office and record the agreement.
This will help to ensure that neither of the parties will lose the paperwork, and it helps the loan agreement to feel real, which has a big psychological effect. It helps borrowers grasp that this is a real loan and that they are responsible for making payments.
Personal loans between family and friends can work when you create an agreement as noted above and consider the potential tax consequences.
It’s always best to keep yourself protected when lending money. As a borrower, you want your family and friends to feel as though they can trust you, and creating a loan agreement is one of the best ways to allay their fears.
You should also keep in mind that there are other options that you might want to consider before borrowing money from people you know. Here are a few for you to think about.
Traditional Personal Loans
Sometimes, getting a traditional personal loan is a better option. It will not make things awkward between you and the people you care about the most. If you have decent credit, you should be able to get a personal loan.
If you aren’t able to get one because of your credit, you might want to see if a family member or friend will cosign for the loan. This way, they aren’t lending you money, but they can make it easier for you to get the loan you need.
Keep in mind that when someone cosigns for a loan, they agree to be responsible for payments if the borrower defaults. This type of loan has its own set of risks.
Along the same lines as a personal loan, there is also the option of a business loan if you are trying to start or grow your business. There are many loan options available for small business owners, as well as many ways to fund your business.
Although credit cards might have a higher interest rate than what you would be charged for a personal loan or for borrowing from friends and family, it still might be a better solution in some cases.
You might find that your family doesn’t have the money available or that they aren’t comfortable lending. A credit card could be a better solution but remember to make those payments just as diligently as you would a loan.
Improve your credit score, and it will be easier to get a personal loan down the line.
Give a Gift
Sometimes, family members or friends who have the financial means might opt for giving someone a gift, which will not trigger any tax consequences and will not require repayment of any sort.
Check to see the current maximum amount that can be given before it starts to become taxable. For small gifts under $15,000, there should not be any issues.
Although some potential issues can arise from these types of personal loans, it greatly reduces the risks when you use the tips and information above. Loans between family and friends can work, but it needs to be done right.
If the loan doesn’t work out, it has the potential to hurt your relationship with people you care about. Always think through the consequences of getting one of these loans and make sure the loan is in writing.