Borrowing Money From Family: 3 Steps to Get It Right
I’ve written before about how to handle family members who are bad with money. (Hint: Don’t lend them money!) But what if you’re the one who’s in a tough financial situation?
A few years ago, I was in that situation. I had graduated college and moved back to my hometown to start my new career. But I couldn’t find a place to rent because of a housing shortage in our community. Faced with the decision to move in with my parents or buy a house, I opted for the latter. The only problem? I didn’t have the money for a down payment or closing costs.
Fortunately, I was able to borrow from my parents who graciously offered to lend me the money for the closing costs and a few much-needed renovations to my home. I took out a USDA Rural Development Loan, which requires no down payment for first-time homebuyers. My parents and the bank called the $3,000 for closing costs a gift, but I knew I wanted to repay them to avoid having money issues affect our relationship.
I’ve been lucky that the loan has never caused problems among us, but I still think that borrowing money from family should be a last resort.
If you do accept a loan, you should make paying it back a top priority when things turn around for you financially. Before you decide to borrow money from or lend money to family, make sure you take these three things into consideration:
- Know the risks of borrowing from family
- Learn the IRS’s rules
- Put it in writing
1. Know the Risks of Borrowing From Family
If you’re the lender, keep in mind that lending money directly to a family member is probably less risky than cosigning a loan for them. At least when you lend money to someone in your family, you know exactly how much of a risk you’re taking. As a cosigner, you could be in much greater financial difficulty than you realized if your family member defaults on the loan.
If you’re borrowing money from family, make sure you have a good reason for accepting the money. You should consider all of your other options first before hitting up your family for money. Don’t play on the guilt or desire of a family member to help you out of a bad financial situation. Show them that you’re going to use the money wisely and that you have a desire to pay them back in a timely manner. This can help avoid letting money upset your relationship.
2. Learn the IRS’s Rules
Depending on the size of the loan, you may be subject to tax implications from the IRS. For a small loans, the IRS doesn’t need to know all the details, like how often you borrow money from family, how much interest you’re charged, or if you ever even pay the money back. But if you borrow a large amount from family, it’s important that they charge you interest.
The amount of interest they charge you must be at least equal to the IRS-approved applicable federal rate (AFR), which can change each month for the three types of term loans. As of January 2018, the AFRs are:
- 1.68 percent for short-term loans (three years or less)
- 2.18 percent for mid-term loans (three to nine years)
- 2.59 percent for long-term loans (more than nine years)
Fortunately, the AFRs are fairly low, but they are higher now than they were a couple of years ago. With a term loan, the AFR of the month when the loan is made is the rate that applies for the life of the loan. If you don’t charge the AFR on a family loan and the loan is more than $14,000, the lender is subject to paying the gift tax unless the borrower agrees to pay the tax instead. The gift tax can be as much as 40 percent.
3. Put It in Writing
To protect both the borrower and the lender, it’s important that family loans be put in writing with concrete terms, rates, and so on. You don’t necessarily have to pay a lawyer to set up a binding legal agreement, though you may want to do so for a large loan. But having a written agreement between both parties can avoid emotional discord. It sets clear expectations, which can help avoid damaging your personal relationship.
For my situation, I created a simple spreadsheet — like an amortization schedule — to show my parents how much I planned to pay them each month, as well as when the loan would be repaid in full. This made it easy for all of us to stay on the same page.
Above all, when lending to or borrowing money from family, it’s important to be open about where things stand. Don’t make all conversations be about the loan, but make sure that both the borrower and the lender are in agreement until the loan is paid off in full.
Further Reading: Learn about taking out personal loans from banks.