Handling Loans From, To Family, Friends

By on Monday, 10th October 2011

The tough economy has a lot of people thinking about borrowing money from a friend or family member, or considering making such a loan.

Those transactions bring unique challenges but, with more and more people trying make ends meet, the possibility may come up. Holiday gatherings only increase the odds of it happening.

On The Early Show Thursday, resident financial guru Ray Martin shared advice to help the process go smoothly, suggesting do’s and don’ts involving etiquette, and wise business.

According to Martin:

A loan from family or a friend may be the only loan you can get. When you borrow commercially, there are more things involved, such as credit scores, documentation and fees, that can be obstacles. And if the loan is for a short period of time, say, a few months, the fees can make getting a loan from a financial institution, or loans such as “pay day loans” impractical compared to borrowing from friends and family.

But that’s fraught with what I call “relationship risk”: There is no other transaction I can think of that can damage a relationship more than just asking for a loan from family or friends. The borrower has to come up with the courage to ask for the loan, and the lender is immediately placed in an awkward situation, almost expected to help, especially if it’s family. It’s stressful for both parties.

What might justify borrowing from family or friends?

Doing so is probably better than going to a “pay day” lender or pawn shop.

Anyone asked for a loan should remember not to lend money to someone who has chronically bad financial behavior. I spoke with a family who had a relative who was asking for a lot of money each month. It turns out she had two cars, each with loans, and she simply refused to sell one of them. So the family was lending her money so she could continue to pay two car payments, insurance, maintenance, etc. each month. If the loan is simply providing money to enable a person to continue to support a poor financial decision, then either make them tell you what they’ll change or, if they don’t, then just say no.

To make it as comfortable as possible for the person being asked:

  • Ask in private
  • Give them an out.
  • Explain need to borrow and dollar amount
  • Tell what the loan is for

    Should the borrower pay interest or agree to a repayment plan?

    When you borrow money from anyone, you should make it a proper and businesslike transaction. That means making it clear in writing in a document called a promissory note, which would include the following:

  • Borrower and lender
  • Amount borrowed
  • Loan term
  • Interest rate
  • Amount of payment and schedule

    It’s important to have a document such as a promissory note (you can search for and download one for free from the Internet, or get one from popular personal finance programs such as Quicken Family Lawyer or Legalzoom.com). In a promissory note, you agree on an interest rate, the term of the loan, the amount of each payment and a repayment schedule, which means how long and when you will make payments. A promissory note is also important because it’s a record of the loan that needs to be repaid by an individual’s estate if the borrower dies before fully repaying.

    You should pay interest and a lender should charge interest. In fact, if you don’t charge interest on a loan, the IRS could take the position that you’re giving a gift, which could raise Gift Tax issues. Typically, the rate of interest to charge without triggering the gift tax is the Applicable Federal Rate, or AFR, which is set monthly by the IRS, and is currently about two-point-five percent-to-five percent per annum, depending on the term of the loan.

    The borrower could offer to give something of value to the lender to hold until the loan is repaid, as an expression of honor and commitment for a borrower to give the lender something for them to hold onto. If that happens, the item doesn’t have to be worth as much as the amount of the loan. That gesture tells the lender the borrower is serious about repaying the loan and wants the lender to know it.

    Before loaning someone money, make it a businesslike transaction, which means insisting on a Promissory Note.

    Also, make sure you’re in good financial shape before you agree to lend any money. You should never take money from your emergency fund, or a distribution or loan from a retirement account to make a loan. You should never borrow from a secured loan, such a home equity line of credit, to lend money to someone.


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