A loan from a friend or relative may be easier to get but having a personal relationship with the lender doesn't let you avoid Internal Revenue Service rates and requirements. Borrowing more than $10,000--even from the bank of mom and dad--requires documentation, minimum interest rates and tax considerations. But one big advantage is that parents and friends don't usually require a stellar credit as banks now do. Here are some things to consider if you are party to a family loan:
Work within the guidelines.
- Mom doesn't require minimums. Parents and grandparents typically don't demand high credit scores or 20% down, but they would be smart to use those as guidelines. It has generally worked for banks and credit unions for ages.
- Lender-set repayment terms. The IRS sets minimum interest rates to avoid income and gift taxes but family members are free to determine the size of the loan and the repayment schedule.
- Government sets the minimum rates. In recent years, the Applicable Federal Rate or AFR has been very low at about 0.46% for loans of three years or fewer, 2.27% for loans of more than three years but fewer than nine years, and 4.05% for longer loans.Check federal rates here.
Put it in writing. Set terms including the amount of the loan, interest rates, payment schedule and length of loan. Consider using a lawyer to draw up a formal note.
- Go online. Look at online services that offer loan administration templates such as LawDepot.com, USLegalForms.com and FindLegalForms.com, but if the loan amount is very large it may be best to hire a lawyer to write up the documents.
- Opportunity knocks. The loan could be good for the lender, especially if they're earning little or next to nothing on bonds, CDs and money market accounts.
- Proper recording. Record the loan at the appropriate authority. If it's for a home purchase, make sure the house has title insurance.
- Proper servicing. Consider using an escrow company to service the loan. They typically prepare tax records, which lenders and borrowers can use.
Opportunities for estate planning. Family loans offer an indirect way to transfer wealth.
- Building wealth. The borrower can use the loan to improve earning power in a business or assets in a home. If it remained with the parent or grandparent, the earnings would be subject to gift or inheritance taxes down the road.
- Prepare for an audit. The IRS is prone to scrutinizing these types of transactions to ensure they really are intended and treated as loans, not as gifts. The IRS likes to see notarized promissory notes with careful records of repayment. If large loans go unpaid, they could slip into the gift category and be taxable to the extent they exceed the annual exclusion, which is now $13,000 for individuals or $26,000 for a couple.
What not to do when preparing a family loan.
- Don't fail to prepare for a defaults or lender's death. The debt is an asset in the estate. Parents often will specifically request that the debt should be forgiven or pass to the person who owes the money.
- Don't forget your documentation. A written formal agreement makes it easier to comply with tax rules that require lenders to pay income tax on the investment interest and borrows to deduct the interest payments.
- Don't be too liberal. We love our relatives, but they don't all make good borrowers. You may need to say no if the family member isn't likely to repay, especially if you need that money for your own living expenses. Don't jeopardize your own retirement security so that your son can buy a house.
For more to read: Don't forget to check the IRS website for information about the Applicable Federal Rate. Check with local escrow companies or banks about setting up automatic deposits from the borrower's account to the lender's account. While lending money, you also need to declare the interest payments on your tax returns. IRS Publication 550 has tax information on the loans. Read more about the steps for a family loan.