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Ideally, borrowing money from friends or family members is an all-around win. You avoid dealing with credit checks and applications, get to keep the money in the family, and can choose an interest rate that’s lower than what the borrower could find elsewhere but still offers the lender more earnings than a savings account.
But you can likely imagine or have stories of family loans that don’t work out so smoothly. Unpaid bills can lead to ruined relationships and awkward family reunions. Even when repayment goes smoothly, the outstanding debt can add a new, unpleasant dynamic to a relationship.
There’s no magic trick for making sure the loan works out, which is why some people advise against borrowing money from friends and family members altogether. However, whether you’re considering a familiar loan as a last-resort or a better alternative to other options, setting a few ground rules could be a good idea.
Create a contract for borrowing money
Even if you completely trust the other person, and they trust you, creating a written contract can still be helpful. The contracts are generally called promissory notes when you are lending or borrowing money, and you .
At a minimum, you want to clarify:
- The loan amount and purpose.
- How much interest will be charged?
- The repayment terms, including how often the borrower will make a payment and each payment amount.
- What happens if the borrower can’t make a payment?
- Who will mediate disagreements?
You probably don’t need to go as far as having a lawyer or a full legal document unless you think you may want to enforce repayment of the loan. Rather, the intent of the contract is to avoid conflict by making sure both parties have clear expectations, and a plain-language letter could serve this purpose better than a potentially confusing document. However, if it’s a large loan, hiring an attorney and drafting a more-formal contract might make sense.
Discuss the potential downsides for your friendship
Some points may require a fair amount of discussion before you come to an agreement. It’s important to figure these out, even if the conversation is difficult.
For example, if the borrower doesn’t make a payment after losing a job or falling ill is this treated differently than if the borrower can’t afford to make a payment but is still spending money on something the lender considers a “want” rather than a need? In that vein, can the lender ever put limits on how or when the borrower spends money?
Or, in a worst-case scenario, what happens if the borrower dies? Is the loan amount forgiven or does the lender expect to get paid from the borrower’s estate, which could create tension between the borrower’s heirs and the lender?
Remember, using “borrower” and “lender” takes some of the emotion out of the discussion right now, but this could result in siblings arguing over an inheritance.
Gauge the other person’s financial capacity
Whether you’re borrowing or lending the money, try to understand how the loan will impact the other person’s finances.
If you’re the lender, you want to know that the borrower can afford to repay the loan as long as there aren’t any major surprises. Or, treat the loan as a gift and know that there’s a chance – but not an expectation — you’ll get the money back.
If you’re in need of money, whoever you ask may feel compelled to say yes as a favor. But borrowers also want to be sure that the loan won’t strain the lender’s finances too much.
When it seems like the loan might not work out well for both parties, it could be best to move on and try to deal with the financial crunch in some other way.
For example, the IRS might automatically calculate and add interest to your income if it finds out you lent money to someone else, even if you didn’t charge the person interest. However, if you’re lending or borrowing less than the $15,000 (the gift-tax exclusion amount as of 2019) without interest, then the IRS may view the exchange as gifting and you won’t need to worry about taxes.
On the other end of the spectrum, most states have usury laws that limit how much interest you can charge on a loan. Often, this ranges from about 10% to 20%.
If you’re at all concerned with the arrangement, you may want to contact a local attorney and accountant who can help you work through the applicable local, state, and federal laws.
Start with small investments
If you’ve never lent or borrowed money with family members or friends before you could test the waters with a small loan. You might enjoy the official yet informal process. Or, you may find that even if the loan is repaid in full without a problem you simply don’t like being part of such an arrangement.
Louis DeNicola is a freelance personal finance writer and credit enthusiast. You can find him on Twitter @is_lou.
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