When it comes to lending money to friends or family members, the simplest and best rule of thumb is Don’t Do It.
Of course, that’s more easily said than done, especially when the person making the request is your oldest childhood pal or your (now grown) baby. “It’s easy to say don’t make personal loans to friends or family, but the reality is that people want to help those closest to them,” says Terry Herr, a certified financial planner with Herr Capital Management in Chicago, Ill.
With credit still tight, financial planners and other experts say it’s not uncommon for adult children to ask parents for loans to help purchase or put a down payment on a house, or for people to tap friends and family for loans to start a business.
The request can also come after a hardship such as a layoff or medical issue that can make it difficult for potential lenders to say no. Eight in 10 consumers would lend money to a family member that has fallen on hard times, and two-thirds would make a loan to a needy friend, according to a new study by ConsumerCredit.com.
If a loved one mistakes you for a human ATM this holiday season, follow these rules to decide whether to make a loan and how to do it the right way.
1. Make sure you can afford it. Before agreeing to make the loan, think carefully about what kind of impact it will have on your own finances. “The last thing you want to do is put your own financial stability at risk in order to make a loan to a family member,” says J.J. Montanaro, a certified financial planner with USAA. “If it’s going to put the squeeze on you, it just doesn’t make sense to make a loan.”
If you can’t make the loan without dipping into your emergency fund or cutting back on your retirement savings, then you can’t afford it.
2. Consider what would happen after a default. A third of potential lenders say they would still lend money, even if they knew it wouldn’t be repaid, according to ConsumerCredit.com. As much as you want to believe that your sister would never leave you in the lurch, you need to consider what would happen if she’s unable to make good on her promised repayment. “You have to ask yourself if the borrower’s past behavior indicates that he’ll meet the obligation, and whether you’ll be OK—both financially and emotionally—if he doesn’t,” says Suzanna de Baca, vice president of wealth strategies at Ameriprise.
If the borrower does fall behind on payments, address it immediately. If necessary, you can renegotiate the terms of the loan to make the debt more manageable.
3. Put everything in writing. The best way to clear up future confusion and possible disagreements is to write down and have both parties sign a document detailing the terms of the loan, including the interest rate, payment schedule and length of the loan. Such a document is legally binding, but—perhaps more importantly-- it serves as a record so neither party can dispute the original terms of the loan. If you’d like to formalize the document, work with a family lawyer, or use the template at Nolo.com.
It’s also useful to record each payment over the life of a loan to avoid discrepancies. A study published in the Journal of Economic Psychology last year found that delinquent borrowers of personal loans report having paid back a higher proportion of a loan than the lender report having received, and they’re more likely to reframe a loan as a “gift.”
4. Loop in Uncle Sam. The loan documentation will also come in useful at tax time, says Eva Rosenberg, who runs TaxMama.com. The IRS requires that private lenders charge interest at or above the applicable federal rate, which is set monthly and tend to be far lower than market rates for loans.
The lender needs to issue the borrower a 1099 INT and declare the interest (and pay taxes on it) on her own returns. Borrowers who use the loan for qualified purpose like a home purchase or business expense may be able to write the interest off on their loans.
If you do not charge interest, and the loan is above the $14,000 annual gift threshold, the IRS could determine that the loan is a gift and come after you for gift taxes. You may also owe gift taxes, for any unpaid principal and interest, if you ultimately end up forgiving the loan.
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