If you lend more than a few dollars to an immediate or extended family member, a formal loan agreement and communication are the keys to making the arrangement successful. The loan agreement doesn’t have to be lengthy and filled with legalese, but should include critical information and protect the interests of both parties. Open and honest communication not only keeps everyone on the same page but may also help to save the relationship if issues do arise.
Issues and Concerns
Loans to family members come with issues and concerns not seen with other types of loans. Some focus on emotions, some on relationships and some focus on potential tax issues. Without clear expectations and a written loan agreement, an family loan can leave both parties feeling disappointed, angry or betrayed. Even with a loan agreement, there’s a chance the loan may never be repaid in full. The question then becomes whether to pursue legal action or accept the outcome and consider it as a lesson learned.
In addition, the borrower may have an expectation the loan will be interest-free. Meeting this expectation means you’ll not only lose any interest the money could be generating if you invested it elsewhere, but lending a large sum without charging interest could cause problems with the Internal Revenue Service. The IRS considers an interest-free loan exceeding $14,000 as of 2015 as a gift it can tax at a rate of 40 percent -- which you’ll be responsible to pay.
Evaluate the Request
You not only have the right to know how the borrower intends to spend the money, but also to seek reassurance about the person’s capacity to repay. Ask the potential borrower for a copy of their credit report from at least one of the three credit agencies -- Equifax, Experian or TransUnion. As you review it, look for negative entries and evidence of any late or missing payments.
Calculate the borrower’s debt-to-income ratio. This is helpful for setting a realistic monthly payment. List and total regular monthly debt payments -- including the proposed payment for this loan -- and divide the amount by monthly net income. A general rule is to keep a debt ratio at or below 36 percent.
Draft a Loan Agreement
A signed and preferably notarized loan agreement becomes a legal loan contract. According to Nolo, the agreement should specify the amount, the interest rate and include the agreed upon terms along with a repayment schedule. Free templates are widely available on a variety of personal finance websites.
Loan terms should address unpleasantness in advance. These include topics like late payment penalties, which party is responsible for bounced check fees, collection costs in the event of default and the rights and responsibilities of both you and the borrower if the borrower defaults.
Establish an open and honest communication pattern from the beginning. A regular meeting schedule -- which you can incorporate into the loan agreement -- increases the likelihood both parties will start out and remain on the same page throughout the duration of the loan. According to Meg Hirshberg, a magazine columnist and author, loans to family members come with risks not seen with bank loans. The most important thing is to preserve the relationship you and the borrower share.