Family Loan: Pros And Cons Of Lending Between Family Members

When borrowing a large sum of money, you might feel safer going with someone you know and trust. For many people, it doesn’t get more familiar than your own family. Other reasons people choose a family loan as their preferred way to borrow money include its lack of requirements – such as a minimum credit score and maximum debt-to-income ratio (DTI) – but borrowing from a family member isn’t always as simple as just asking for money.

Let’s delve into the hidden complications of family loans, along with their upsides and downsides for both the borrower and the lender.

How Does A Family Loan Work?

The process of getting a family loan is typically far more informal than borrowing through a traditional bank, credit union or private lender, and the terms of the loan are decided between you (the borrower) and your family member (the lender).

A family loan may but may not include these terms as part of its agreement:

• An agreed upon interest rate
• A repayment plan (installments, lump sum, etc.)
• A down payment
• Collateral

Some family loans can be more formalized with a signed loan agreement, but this isn’t always necessary. Borrowers with a low credit score or no credit history can benefit from a family loan if – as is often the case – a family member is more lenient than a traditional lending service.

However, relationships between family members can become strained if the loan recipient fails to repay the money they’ve borrowed according to the terms of the borrowing arrangement. Additionally, family loans can come with tax implications for both the borrower and lender, so more may be more at stake than initially meets the eye – potentially leading to some uncomfortable family gatherings.

Pros And Cons Of A Family Loan

For all the advantages that family loans can offer, some disadvantages exist as well. Let’s break down the pros and cons.

Pros

Family loans can benefit borrowers and/or lenders in these ways:

• An easier approval process: Typically, family members exchanging money won’t require you to submit any proof of identity or income. A family lender may also go easier on a borrower with a low credit score, and the family loan lender may not run a credit check at all.
• Potentially lower interest rates: If a family lender charges interest, the rate can be set at their discretion, or agreed upon between them and the borrower. Borrowers could save money with a lower interest rate than they’d find by going the traditional lending route.
• The borrower and lender having a personal relationship: When borrowing from family, you’ll generally know the lender personally. You may feel safer borrowing from someone familiar because you’ll know you’re not at risk of falling for a lending scam.
• Potentially flexible repayment terms: A borrower and lender in the same family can discuss the preferred repayment terms, including whether the money is to be repaid in installments, a lump sum or another way. The family lender may also be more forgiving of a late payment than a traditional lender would be.
• Lenders possibly earning money through interest: If a family lender charges paid interest, they could earn a return through that interest.

Cons

People on one or both sides of the loan may also experience these downsides:

• Borrowers being unable to build credit: Because family loans are between family members, a borrower’s on-time payments aren’t reported to the credit bureaus. As a result, you won’t build credit by repaying a family loan.
• Lenders possibly not getting their money back: If their family member defaults or misses multiple payments, the family lender may find it hard to get their money back. A lending institution would hand the debt off to collectors, but a family loan is often considered a private matter.
• A family relationship being put at risk: Late payments or a default could sour a relationship between relatives. Consider the effect that not repaying a loan, missing payments or making late payments could have on family relations.
• Lenders facing tax implications: The IRS may require that family lenders charge a certain amount in interest. Otherwise, the loan may be liable for a gift tax. The family lender must pay interest on any income they make off the loan.

How To Make A Family Loan Agreement

Drawing up a loan agreement or promissory note, even between family members, is a smart way to ensure a family loan goes smoothly and covers all tax requirements. Here’s how you can create a binding and fair contract for a family loan.

1. Agree On The Amount Being Borrowed

Before anything can go into writing, both parties must agree on how much is being borrowed. There’s no legal limit on how much one family member can loan another, but loans over $10,000 will have certain tax requirements, which we’ll look at more closely below.

For the sake of the family loan agreement, make sure the loan amount the borrower and lender agreed on is in writing before any transactions occur.

2. Discuss A Fair Repayment Schedule

As with traditional lending, a family loan agreement should specify a repayment schedule. This should outline the repayment terms of the loan and include payment frequency, payment amounts and the expected payoff date.

3. Set An Interest Rate

If a family loan is $10,000 or less, the lender can decide whether they want to charge interest and how much. On loans over $10,000, though, the IRS requires that you charge a minimum interest rate known as the applicable federal rate (AFR) – the amount of which is set every month.

Lenders may need to report earned interest as income when filing their taxes. If a lender doesn’t charge interest over a certain amount, they may owe a gift tax.

4. Make Clear What Happens If The Loan Isn’t Repaid

Both family members need to discuss the implications of failing to repay the loan, whether that means the lender taking legal action or accepting the loss.

It’s not wise to lend to family if there’s uncertainty about the borrower’s income covering the repayment, but an emergency may also prevent the family member from making payments as planned. Both parties should know what’ll happen in these situations.

5. Determine If There’s A Prepayment Penalty

Intended to make up for lost interest, a prepayment penalty is a fee charged to the borrower for paying off a loan early. Many lenders don’t charge prepayment penalties, but it’s up to the family member lending the money to decide if they want to have one.

Having an attorney present when writing out a family loan agreement could help ensure the process goes smoothly and all legalities are considered.

Family Loan Alternatives

If the drawbacks of a family loan have you concerned, other types of loans and financing options are worth considering.

Alternatives To Loaning Money To Family

Rather than loaning money to a family member, it might be best to explore these other ways of providing financial assistance.

Gifting The Money

If affordable, simply giving money to a family member in need might be easiest. A gift of over $17,000 from one individual will incur a gift tax from the IRS, as will a gift of over $34,000 from a couple.

Co-Signing A Loan

Co-signing a loan with a family member is possible if the co-signer’s credit is in better standing. The co-signer is responsible for any payments the primary borrower misses, or the entire loan if they default.

Making The Family Member An Authorized User

A family lender can also invite their family member onto a credit line as an authorized user. This way, the family member has access to the funds as needed and can boost their credit score in the process. Any payments due are the cardholder’s responsibility.

Alternatives To Borrowing Money From Family

It can be awkward being on the borrowing end of a family loan, too. Look into these options if you’re unsure about a family loan.

Getting A Personal Loan

A personal loan can be used for various purchases or costly bills. Eligibility is based on your credit score, which should be at least 650 for a good interest rate but could be as low as 610 and not stand in the way of loan approval. The personal loan application process is relatively quick and straightforward, and you’ll likely receive your funds within days of approval.

Use A Cash Advance

With a credit card cash advance, you can borrow money directly from an ATM. There’s no credit check involved since you’re already a cardholder. Cash advances come with expensive fees, however, and interest accrues from the moment of the withdrawal.

Try A Small-Business Loan

If you’re borrowing funds to start a small business, research your options for a small-business loan. The Small Business Association (SBA) backs loans for qualifying businesses and can lend upward of $5.5 million.

FAQs About Family Loans

With family loans perhaps being more complex than you originally assumed, here are some additional clarifying questions and answers.

Can I legally borrow money from family?

Yes, and having a contract in place for the loan can help ensure all legalities and tax implications are considered. If legal action over a default is taken, a written family loan agreement can support such a case.¹

How much can a family member loan me?

There’s no legal limit for how much a family member can loan you, but there are tax requirements. Loans over $10,000 are required by the IRS to charge the applicable federal rate and then report that earned interest as income.

What is the best way to loan money to a family member?

Crafting a written family loan agreement is the best way to ensure a family loan is understood between family members and arranged within legal limits. Participating family members should discuss the details and terms of the loan, and have an attorney present if possible. 

Can I lend money to a family member tax-free?

Family loans under a certain amount shouldn’t carry any tax implications. For higher loan amounts, though, interest earned by the lender is required to be reported as income. Family loans over $10,000 must charge the federal applicable rate set by the IRS.

Final Thoughts

Family loans can seem straightforward on the surface, but they often involve far more than one family member simply passing money to another. It’s important that both lender and borrower understand the terms of the loan, especially what happens if those terms aren’t met. The lender should also understand the tax implications of providing a certain amount of money to their family member in need. For many people, looking into other financing options and avoiding potential family drama might be the safest bet.

If you want to see your options for a personal loan, start an application today with Rocket Loans℠.

¹Rocket Loans does not provide legal or tax advice. The information herein is general in nature and should not be considered legal or tax advice. Consult an attorney or tax professional regarding your specific situation.