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What To Know About Intra Family Loans

What To Know About Intra Family Loans

Money is a fun thing when it passes between family and friends, especially if you are the one who borrows or lends a loan to a family member or close friend.

The Federal Reserve's consumer credit survey shows that loans from family and friends are $89 billion a year in the United States. Finder did some math after a 2018 survey and said the figure was around $184 billion. Either way, there is a lot of money flowing between family and friends.

The most common reasons for borrowing money from family or friends are starting a business or buying a home. A national survey conducted by Fundable showed that 38% of startups depended on money from family or friends. The National Association of Realtors said 52% of first-time homebuyers used family money, especially relatives or friends, to buy a home.

Another good reason to apply for a loan from your loved ones is when a family member unexpectedly becomes unemployed or suffers from a sudden illness. Other common reasons include buying a car, computer, or other technical equipment or something more personal, like an engagement ring or paying for a family vacation.

How to borrow from friends or family

The main advantage of getting a loan from a friend or relative is that your "lender" is more likely to be flexible about how much you borrow and how to pay it back. This means that you can borrow 100% of the amount you need at a very low-interest rate, maybe 0%, and have an affordable monthly payment schedule.

Treat a personal loan issued by a loved one with the same respect and professionalism as a bank loan. Suppose you intend to borrow money from a bank, credit union, or other lending institution. In that case, you already know that you should be prepared to sign a legal contract that outlines the obligations to the creditor: from one-off payments to full repayment of the loan. This contract is called a promissory note.

Should it be any different if you borrow money from friends or family? While they may have known you for years or even a lifetime, they still need the guarantee that you will return the money you promised. Just knowing them so well does not eliminate any of the obligations and responsibilities associated with obtaining a loan.

It is recommended that you write and sign a loan agreement regardless of your relationship with the lender. This protects both parties in the event of a disagreement. A loan agreement between two people is simpler but very similar to a regular banknote.

The basic terms of a loan deal with family or friends should include:

  • The amount borrowed (capital)

  • Interest rate (if applicable)

  • Repayment terms (monthly payments for a specific period or a fixed amount on a specific date)

One of the most important things you need to do in a loan deal with a friend or family member is, what if you can't pay it off?

The loan agreement must clearly indicate the lender's remedies in the event of default, including:

  • Add additional costs to the loan

  • Modify the loan conditions

  • Accept ownership of the collateral

  • Taking legal action

What happens when you default?

Like any loan agreement, you have legal debts. If you do not respect the terms of the contract, your lender, in this case, your relative, can sue you. With the contract as evidence, the creditor can sue in small claims court, receive a judgment, and then perform debt collection activities, such as property lien or wage garnishment, just like other creditors.

Suppose you can't negotiate more reasonable loan terms privately. In that case, a lawyer can negotiate on your behalf to include a portion of the outstanding balance in a debt settlement agreement or add it to a debt consolidation loan. You must take action before a decision is made in a small claims court, as the lender can often track your assets, bank accounts, and wages.

Open Communication

Everyone has their ups and downs with their finances, but things really get complicated when you take your family or friends on a roller coaster ride to pay off a loan. Relationships built over the years, if not decades, break down when the terms of a loan agreement are ignored or violated.

If you're late with your loved one's loan, it's important to keep the lines of communication open. Good communication is the best way to avoid animosity with family and friends who have loaned you money. Like it or not, a person borrowing money feels like an investment. They want to know how the project or business is going and if the loan will be repaid.

It's easy to come to a verbal agreement with family and friends, but it's hard to remember the details a year later. This is why it is so important to have everything ready on paper. Take note of everything and make sure both parties understand the details of the agreement.

The borrower should consider providing lenders with regular updates (monthly, quarterly, or annually) to discuss the project or business. It helps to know in advance if there may be any issues paying off the loan and if there are other options to help you while the issue is resolved.

Finally, both parties must anticipate that there will be weaknesses and decide in advance how to respond to them. Emotions increase when both parties seem to be losing money. There isn't much to be gained by having a heated discussion with family or friends about debt.

Both parties need to be realistic about what is expected and the borrower should give maximum priority to repaying the loan. At the same time, the lender should expect problems and is probably why the loan was requested in the first place.

What to do if you are a creditor

The lender has more to lose, literally and figuratively, in situations where there is a loan agreement with family or friends. The lender not only puts their money at risk but also their reputation and relationships. You can lose everything - money, family, and friends - if things go wrong, and you can earn a little more than a few dollars in interest if everything goes well.

This is why people should think carefully before lending money to their family or friends. It can be a costly exercise.

Here are some things to consider before giving out the loan:

  • Have all other options been exhausted: banks, credit unions, other family members?

  • If creditors won't give them the money, are you sure you want to take the risk?

  • What is your family's equity, and can you afford to tie up money for such a period?

  • Would you be involved in a project or business to help you get your money back?

  • Would you be prepared to foreclose on the borrower's mortgage or sue if the loan is in default?

  • Would you impose late penalties?

If you have factored in all the negative outcomes of giving out a loan and have decided to continue, here are some steps that can help you achieve a positive outcome.

  • Ask for a plan. The borrower should provide details of how the money will be used, the repayment schedule, and what will happen if the loan is not paid.

  • Define conditions that both parties agree can be enforced and enforce them!

  • Keep your distance. Just because you've given someone a loan doesn't mean you can get involved in a project or business.

  • Make sure they understand it is a loan, not a gift.

  • Review the borrower's finances and help them set up a budget that includes the monthly payment.

  • Write on paper. Discussions are easier to resolve when everything is written and signed.

Tax implications of a family loan

According to the US Federal Reserve's Consumer Finance Survey, loans from family and friends are $89 billion per year in the United States. The most common reasons for borrowing money from family or friends are starting a business or buying a home. A national survey conducted by Fundable showed that 38% of startups depended on money from family or friends. The National Association of Realtors said 6% of first-time homebuyers used family money, mostly from their parents, to buy a home.

Dealing with the IRS is one of the critical but often overlooked aspects of loans to family or friends. Both borrower and lender have responsibilities, although most of them fall on the borrower.

The first thing the IRS wants is clear proof that it is a loan, not a gift. This means charging and collecting interest in accordance with IRS rules for the applicable federal rate. The minimum rate in 2021 is 0.25% for loans of less than three years, 0.58% for loans of three to nine years, 1.15% for loans greater than nine years.

If the parties involved don't pay and receive at least that amount of interest, the IRS may treat the money as a "gift" and levy gift tax, depending on the amount.

The next step is to prepare the legal documents for the loan. If the loan is for a house, it includes a trust deed and a county loan register.

Both parties must sign a promissory note detailing the interest rate, terms, length of the repayment period, and the option of transferring the loan to another party.

There should also be an amortization schedule showing the amount of principal and interest paid and the balance owed each month during the term of the loan.

The lender must file IRS Form 1098, showing how much interest the borrower has paid each year. The lender must also complete IRS Form 1099, which shows the amount of interest you received on loan, and report that amount on your tax return. This is an essential step in the loan process, as there will be serious tax consequences if any of these steps are skipped.



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