A family loan agreement, also known as an “intra-family loan” is a document used whenever money is lent between two (2) family members. The document provides clarity for both the borrower and the lender, giving clarity as to what is expected from both parties. Lending between family can be rewarding for all involved so long the seriousness of paying back the money is understood and the deal is done with as little emotion as possible.
If a family member asks for money in a time of need, it may be tempting to provide the funds so long they agree to pay back the loan. One might think requiring their family member to sign formal documentation could damage their relationship or make the lender come off as untrusting. In reality, requiring written documentation in the form of a loan agreement promotes greater family unity and respect more than any verbal agreement can provide.
Like all types of lending, lending to family members comes with its own set of benefits and risks, which include:
- Flexible terms – Unlike standard loans, the agreement can be structured however the parties wish. Additionally, the lender can alter the terms of the loan to accommodate changes in the borrower’s life.
- Lower interest rate – Even if the borrower has a great credit score, rates offered by banks don’t come close to the lowest rate that can be charged among family (know as the AFR, or “Applicable Federal Rate”.
- Helping hand – For family members suffering a financial crisis, the loaned money can serve as a lifeline in a time of dire need.
- Ruined relationship – Although a loan agreement helps to reduce fractured relationships, verbal arguments and distrust can prevail if the borrower doesn’t respect the terms they agreed to.
- Taxes – For loans over a certain value, the IRS requires taxes to be paid on the interest collected. If the lender charges an interest rate that is lower than the AFR, the lender is still required to pay taxes on both the interest earned as well as the difference between the AFR and the interest rate that was charged.
- Missed payments – Arguably, the most obvious risk is that the borrower can stop (or refuse) to make payments on the loan. Short from taking the family member to court, there is little the lender can do to collect the money lent.
Take time to listen to exactly why the family member needs money. If something doesn’t feel right, it’s probably for good reason. However, with all things money, removing emotion from the equation is recommended. Use the lending checklist below to aid in making a fair and reasonable decision on whether or not the family member should be lent to:
Before lending money to a family member, go through the following questions to determine if they’re a good fit to receive funds:
- What would they use the money for?
- Are they responsible with their money?
- Are they currently in debt?
- Have you lent to them in the past?
- Did they pay back the loan?
- Did they do it in a timely manner?
- Will loaning money cause jealousy among other family members?
- Would my significant other (if any) be okay with loaning the money?
- Are you okay with losing the loaned money?
The last point, referring to whether or not the lender would be “ok” with losing the loaned money, is arguably the most important question. One should not loan money with the expectation of getting it back if they value their relationship with said family member. That is how family relationships are changed (for the worse) permanently.
By mentally viewing the loan as a gift, the lender is not emotionally devastated if the loan goes unpaid. Having said, the lender should not share this with the borrower – this is merely a mindset that the lender should have prior to lending money.
The loan agreement establishes several important points regarding the lent money. By requiring the borrower sign the agreement, it helps to ensure they understand the seriousness of the loan, and that they’re required to follow the terms within it. It also serves as a record of the deal, letting the lender look back on the terms they offered should they receive another request for money from another family member.
At a minimum, the agreement should include the following information:
- Loan amount ($);
- The date the money was lent to the borrower;
- Both the names and addresses of the lender and borrower;
- The repayment structure for the loan;
- Date of the first payment;
- Amount ($) of each payment; and
- Day of the week or month payments are due.
- Whether interest will be charged (and if so, how much interest); and
- The signatures of the borrower and lender.
Once the agreement is signed, a copy should be kept by both the lender and the borrower.
The lender can now provide the borrower with the amount ($) as stated in the loan agreement. This should be done by providing cash, a check, depositing the money in their bank, wiring the money, or paying for the expense directly.
Alternatively, the lender can provide the loaned money in chunks at times the borrower needs it. This can help to ensure the borrower allocates the money towards the expenses they agreed to use the money for. However, if the lender intends to do this, it must be clearly stated in the loan agreement that they intend to pay the borrower in this fashion.
Once the money has been provided, the parties should revert to the terms and conditions as stated in the loan agreement. The lender should keep a record of all payments, noting the time they were made, the amount paid towards interest and principal, and the remaining balance owed. If the borrower is late on a payment, the lender should “check-up” on the borrower to see the cause. If they simply forgot (and they make the payment in full shortly after), the lender shouldn’t treat it as a big deal. However, to establish the importance of the loan terms, the next payment due date should remain the same – not pushed back to a later date.