Loans to Family Members – How to Do It Right

by Neal Frankle, CFP ®

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If you can find a way NOT to loan money to a family member or friend, by all means that’s your best bet.  Of all the financial mistakes I’ve ever seen, loaning money to family or friends is probably the biggest.  When someone comes to you looking for a bail out point them in someone else’s direction.

It can create a great deal of financial stress. It can tear families apart. In fact, this almost happened to me.

Right after I got married, I loaned a small amount of money to someone in my family (since most of the people in my family read the blog…let’s leave it at that). When I made the loan, the person who got the money thanked me. I told him not to mention it. Unfortunately for me, he took my advice. He never did mention it again, nor did he repay me. BAH!

When I confronted him after a few years, he told me that he considered the money a gift and as a result, felt no need to pay me anything. Rather than create a huge rift, I wrote it off.

But I learned a few very important lessons about making loans to family members.

1. Don’t loan money to friends and family if at all possible.

If you need to make a gift, then do so. Even if the recipient assures you that payments will be coming, think of this money as a gift. Believe me, you’ll live longer this way.  On the other hand, sometimes you do other people a favor by turning them down.  If someone is in debt and you bail them out, what’s to stop them from getting into trouble again and again?  Nothing.  If someone has a debt problem, you might want to help them fix it but that doesn’t always mean you write a fat check.

2. If you simply must make the loan, at least get the terms in writing.

I don’t care how much you trust this person. I don’t care if you are loaning money to your brother-in-law who saved your life by donating his lung to you — get it in writing. And while you’re at it, have all the spouses sign as witnesses to the agreement. This is crucial. You don’t want anybody to misunderstand. This is a loan and must be repaid.

4. Even if you don’t care about making a profit, charge interest and get monthly payments starting now.

This move is to further communicate to the recipient that this is a loan, not a gift. It also helps your cash flow. Also, you must charge the minimum rates set forth by the IRS. If you don’t, the IRS will consider this a gift and it could trigger tax consequences. You can find the IRS minimum rates by going to Google and pasting in these key words: IRS Applicable Federal Rates Table 1. (It’s a pdf and it gets updated weekly so I can’t post a link. Sorry).

If you end up making the loan, chances are you had no choice. I get it. Don’t feel bad.

If you are lucky enough to lend the money to someone who actually pays you back (please don’t hold your breath), you’ll probably get more in interest than you could had you deposited the money in the bank.

I’m not a fan of making loans to friends and family. (Can you tell?) I’ve had bad experiences. Am I the only one who got burned? How about you? Make me feel better. Share your war stories with me. Please…

 

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