Lending Money to Family and Friends

Many people in this world do not have access to personal loans such as mortgages or automobile loans for one reason or another.  This may be because they have no credit or because they have bad credit and can only obtain a loan with an above-market interest rate attached to it.  In these cases, people often turn to family members or friends.  According to a Federal Reserve Board Survey of Consumer Finances, loans from family or friends amount to around $89 billion each year in the United States.  Some of the reasons for the loans are to start a business, purchase a home or assist a family member or friend who has fallen on hard times.  Over the years, I have assisted a fair number of people in lending money to family members or friends.  Some things I would recommend everyone consider before making such a loan are:

• What are the personal consequences of lending money to a family member or friend?
• How should I lend money to a family member or friend?
• What are the tax implications of loaning money to a family member or friend?

What are the personal consequences of lending money to a family member or friend?

If a family member or friend asks you for a loan, you have to decide whether you are willing to loan that person the money and what the personal consequences might be. You have to first ask yourself whether you are in a financial position to loan the money.  If money is tight, you probably don’t want to make the loan.  Even if you are in a financial position to make the loan, you still might not want to do it.  Many times the person you are lending the money to does not take his or her obligation to repay the loan as seriously as he or she might if he or she was getting the loan from a bank or other independent third party.  In fact, many borrowers believe one of the main advantages of receiving a loan from a family member or friend is the thought that the family member or friend will be more flexible with payment arrangements.  For this reason, you should ask yourself the following questions before making the loan:

• Would loaning the money jeopardize your own financial situation, now or over the life of the loan?
• Would the relationship I have with the borrower be jeopardized if they are not repaying me in a timely manner, or if they never pay me back?
• Would the relationship I have with the borrower be jeopardized if they were spending money extravagantly on other items, such as posh vacations and luxury automobiles, before repaying me

If the answer to any of these questions is yes, then you probably don’t want to make the loan.

How should I lend money to a family member or friend?

Over the years, I have seen many people simply hand loan proceeds to a family member or friend and say “pay me back when you can.”  My experience from the lender’s perspective in these cases is that it doesn’t end up well – meaning the lender rarely gets paid back.  If you decide to loan money, I would recommend that you treat the process as much as possible like the borrower is obtaining a loan from a bank or independent third party.

The first step in this process is to do some financial due diligence of your own on the borrower.  Although I don’t think it is absolutely necessary, consider obtaining a credit report.  Consider requesting the borrower’s income and expense information and asking for a plan for how they are going to repay you.  This includes making sure they understand they have an obligation to repay you according to the terms and conditions the two of you agree upon.

The second step in this process is to memorialize the transaction in the form of a promissory note.  A promissory note is a legally enforceable contract in which the borrower promises to repay the loan according to the terms and conditions contained in the note. The note should contain the amount borrowed, the interest rate and the repayment terms and be signed and dated by both the borrower and the lender.  You can enlist the services of an attorney to assist with the drafting of the promissory note, but it’s not required.  The protection it affords the lender is that if the borrower fails to pay, or is late with a payment, the lender has a legally enforceable contract by which he or she can hold the borrower accountable under the law.  In the absence of a promissory note, the borrower could argue that the loan was not a loan at all, but a gift from the lender to the borrower.  If the borrower is successful with this argument, the borrower has no obligation to repay the loan.

What are the tax implications of loaning money to a family member or friend?

Generally speaking, as long as the loan bears a market interest rate – in this case market interest rate is defined as the applicable federal rate as established monthly by the Internal Revenue Service – the lender reports the interest payments as interest income on his or her income tax return in the year in which the interest is received and the borrower may or may not be able to deduct the interest on his or her income tax return, depending on what the loan proceeds were used for.

If you don’t charge interest or if you charge an interest rate that is lower than the applicable federal rate, then the Internal Revenue Service will impute interest to the lender at the applicable federal rate in existence at the time the loan was entered into.  The amount of the imputed interest is considered income to the lender and must be reported on the lender’s income tax return.  In addition, the amount of imputed interest charged to the borrower is considered a gift from the lender for gift tax purposes.  If the amount of the gift exceeds $15,000 in any one year, the lender will be obligated to file a gift tax return. There are a few exceptions to the imputed interest rules, the most notable exception being that if the loan amount is $10,000 or less, the rules don’t apply.

These are just the highlights one should consider prior to loaning money to a family member or friend. Every situation is unique and each can present other important items that need to be considered.  As in all major financial decisions, it is best to discuss your personal situation with your financial advisor prior to making any significant financial commitments.