As the wellsprings of consumer financing have begun to dry up in response to the current economic crisis, informal lending among friends and family has been gaining in popularity and momentum. While there may be a natural pull or even a sense of obligation to help friends and relatives in their time of need, many experience complications later on.
So how does one successfully lend money to friends and family while preserving relationships? The key to lending money to acquaintances is keeping things clear and professional. Though this may feel a bit awkward at the beginning, doing so will prevent future disputes and discomfort down the road and will help ensure that everyone involved benefits.
Here are some guidelines on how to properly lend money to friends and family:
Decide How Much Money to Lend
Because lending money to loved ones is often a sensitive subject, it is important that both the lenders and borrowers set realistic expectations. In some cases, it may be better for everyone if the transaction is considered a gift.
When gifting the money is not appropriate, then the lender should consider the following:
- Can the lender afford to lose the money if the loan is not repaid? (This includes the loss of income had the money been invested.)
- What are the circumstances of the borrower? Can the person be expected (and trusted) to repay the loan in a reasonable amount of time, and how does the borrower intend to use the money?
Get a Third Party Involved in the Loan
An impartial third party can help keep the lending process professional and the expectations clear. When a large sum of money is being handed over, a qualified lawyer or accountant should help draw up the paperwork.
Another popular option for a third party is to work with a peer-to-peer lending website, such as Virgin Money or Prosper.com. These sites act as loan intermediaries between friends and relatives. They offer a range of services, such as creating promissory notes, setting up electronic loan payments, collecting money, and reporting a loan default to the credit bureaus.
Hash Out the Details of the Loan
Make sure that the details of the loan are clear to all parties involved and that these details are properly documented in a notarized promissory note. The details to work out include: the exact loan amount, the rate of interest that will be charged, a repayment schedule, and any security or collateral. There should also be a section detailing what the borrower should do in the case of financial difficulty.
Do Not Forget the IRS!
When lending money to friends and family, one should be familiar with the guidelines set out by the IRS that effect whether the loan is considered a gift and that have other important tax ramifications.
First, the lender and borrower should be aware that for private loans over $10,000, the IRS requires that a minimum amount of interest be charged. If this interest is not included, then the IRS will tax the lender as if the full interest money had been received. The correct interest to charge on the loan should be based on the AFR (applicable federal rate) which will vary depending on the length of the loan. The IRS publishes AFRs monthly in the Internal Revenue Bulletin.
Second, in the case where the loan is not repaid and there was proper documentation, the lender may be able to claim a short-term capital loss tax deduction.
In short, by having a little foresight from the beginning, one can avoid the discomfort in lending money to friends and family later on.
Susan Brown - Susie Brown is a small business consultant and freelance writer specializing in business and personal finance.
Join the Conversation