Handling Loans From, To Family, Friends
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:
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:
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.
If the borrower doesn't repay on schedule, what's the best course for the lender to take?
The reason the promissory note is important is that it spells out the terms of the loan and a repayment schedule. If the borrow can't repay on schedule, you need to discuss with him or her some options for how to make the missed payments. The options can include adding the missed payments into the remaining payments or adding the missed payment to the end of the loan.
Since the loan is between friends or family members, does it have to be reported to the IRS?
Technically, you don't "report" loans to IRS, but what you need to do is to decide if this is going to be a loan or gift. If it's a gift and exceeds the current $12,000 annual gift limit, then you may have to report it as a gift by filing an annual gift tax return. If it's a loan, you should have a promissory note and charge fair rate of interest (the AFR, or Applicable Federal Rate). The interest someone pays could be considered interest income to the lender.
What if the person you ask for the loan says no, or "I don't have it?"
You should consider some alternatives. If they say they're unable to come up with the cash to loan to you, then ask them if they would be willing to be a co-signer for a loan from a bank. Often, a person needing to borrow due to financial difficulty will also have some damage on their credit reports and low credit sores. That results in high interest rates and extra fees. But interest rates on loans where there's a co-signer with good credit can be about half what it is when taking out a loan without a co-signer. But the co-signer is responsible if the borrower defaults on the loan and would need to make the payments to avoid the borrower's default from hurting their own credit history and credit score. It could also hurt the relationship.
Another alternative is to check out peer-to-peer lenders. More and more people are said to be turning to such lending services, which facilitate loans between related and unrelated people. In essence, these peer-to-peer lending services enable a cash-strapped individual to get a loan from another person who is willing to lend out his or her own money. Typically, the rates on these loans can range from 8.5 percent to 10 percent and can be found on Web sites such as Prosper.com and Lendingclub.com.