Family loans can provide access to cash for family members who need help, but there can be some potential legal and emotional pitfalls. Those considering lending to members of the family should have clear loan contracts to set out expectations for all parties involved, and may want to do some investigation before transferring funds. Like a commercial lender, a family member wants to be sure a loan can be repaid, and should limit the amount of money offered if a big loan would be a hardship. It can help to work with an accountant or attorney to develop a contract.
The advantage to family loans is that they can provide people with financial assistance they might not otherwise be able to access. This could include money for an emergency or funds that wouldn’t be provided by a conventional lender. Alternatively, people could access financing in other ways, but might prefer lower interest with a loan from a family member. Some may use borrowed funds to pay off debts, make a down payment on a house, buy a car, or engage in other activities.
One potential issue with family loans is emotional. Borrowing money can create a different power dynamic, especially if it involves an older family member borrowing from a younger one. The process of repaying the loan could become emotionally fraught, especially if there is a problem that requires the suspension of payments, or if the family member doesn’t repay the money at all. Fragile family relationships may not always survive a loan gone bad.
There are also legal and tax issues with family loans that should be carefully addressed. Tax authorities may consider a loan a gift, in which case the recipient needs to pay taxes. If it is explicitly a loan, there’s a chance that the lender could be charged with “imputed interest.” Tax agencies assume all loans come with interest, set at least at the market rate. Even if a loan is interest-free, the government may decide that interest has been paid, in which case the lender owes taxes on it, because interest is a form of income.
People considering family loans should sit down with the borrower to discuss the amount and how it will be used. They can also develop terms of repayment, including interest if the lender wants to charge interest. This information can be used to set up a clear contract documenting the fact that the money is a loan, not a gift, that repayment is expected, and that both sides have obligations. One option to consider is requesting an interest in the asset for protection, like sharing the title of a car until the loan is paid off.