Loaning Money To Family: A Comprehensive Guide

For many, the No. 1 rule about loaning money to family is: DON’T DO IT!

While providing a helping hand to a family member is certainly a kind and even admirable act, it’s also fraught with danger that can lead to everything from awkward holiday meals to “I’m never speaking to you again” hostility.

But if you’re sure your relationship with a family member can overcome the tensions of them being indebted to you, there are a number of things to consider before making a loan, as well as ways to ensure that the process plays out smoothly and ends happily.  

What Does It Mean To Lend Money To Family Or Friends?

When you decide to financially help out a friend or family member, two things can be true at once: first, you’re a nice person who is trying to offer a helping hand; and second, you’re changing the dynamic of your personal relationship. In other words, your good intentions have now turned a person who is close to you, at least in part, into your debtor.

Technically, a loan isn’t the only way you can help a family member or friend financially. These kinds of grants can take the form of a loan or just an outright gift.

• Loans: With this type of financial outlay, you become like a bank. The person accepts your money and promises to pay you back, in full, and with interest if that’s the agreement. To solidify this agreement as a true loan, it should really be in writing and include a payment schedule like any other loan.
• Gifts: Sometimes people will “lend” a family member money with no formal agreement or understanding that the money will be paid back. The borrower might say “I’ll pay you back when I can,” but that really holds no weight. If you send money to someone with this arrangement, you should likely accept that you’ll never be paid back. It’s just a gift, and that was very nice of you.

The Pros And Cons Of Lending Money To Family: At A Glance

The dynamics created when you lend money to a family member are tricky and can be considered as high risk/reward. Here are some of the key pros and cons to consider before you loan money to family.

4 Tips For Lending Money To Friends Or Family

If you decide to lend money to a family member, do so with your eyes wide open and with careful consideration of the negative consequences. Here are some sound principals to bring to the agreement for both you and the borrower.

1. Lend Only What You Can Afford

Another way to express this principal is “lend only as much as you can afford to lose.” If the person is unable to pay back all or even some of the money you’ve lent them, it should not be so much that it affects your personal financial dreams and goals. For instance, if the amount you’re lending sets back your retirement fund savings by several years, it’s probably too much to lend out.

2. Evaluate Your Reasoning For Lending Money

If you’re considering lending money to a family member, or if someone close to you has come to you about a loan, you need to assess the idea objectively and ask yourself if you’re doing this for the right reasons.

If the amount they seek is reasonable, if they are using the funds for a worthwhile goal such as a down payment on a house or to pay off a high interest credit card debt, if they are a hard worker with a good job — these are all positive reasons to give them a loan. However, if the person is unemployed or not serious about work, if their reasons for needing a loan are unclear, or if they seek a larger amount of money than you are comfortable parting with — these are warning signs for you to back away.

3. Make Sure You Trust The Person You’re Lending To

To have an idea how it might go if a family member borrows money from you, look at your current relationship before the loan. If this is someone you like and admire, has a good relationship with you and other family members, and is generally a stable, hardworking person, you can feel strongly that they will eventually pay you back. But if your current relationship, before you lend them money, is difficult and unstable, if the person is not reliable, or if they are manipulative and trying to guilt you into lending them money, then this is probably not a person you should trust to repay the loan.

4. Create And Abide By A Written Contract

Because interfamily loans are typically between two parties who have a close personal relationship, many are conceived of very informally, with the borrower expected to pay the money back on the “honor system.” This is not a good idea because it creates uncertainties that often lead to conflict. For this reason it’s best for the borrower and lender to have a signed written document that governs the loan.

How To Create A Family Or Friend Loan Agreement

The principals of the loan can be outlined in a simple handwritten document signed by both parties, but for a larger loan where the stakes are higher, it’s probably best to hire an attorney to make sure the document is legal and valid. In any case, the contract should include:

• Names, addresses and signatures of all parties involved
• Amount of the total loan
• Repayment schedule, including monthly payment amounts and date of final payment
• Interest rate being charged, if any
• Penalties for late payments
• Understanding that borrower is legally bound to repay the debt and at risk of lawsuit if they default

Alternatives To Family Or Friend Loans

If you’d like to see a family member get some financial help, but you’re concerned that your relationship with them could suffer damage if you lend them money, here are some alternatives to a private loan:

• Gifts: Sometimes when the lender is wealthy enough or the loan is fairly small, the lender might choose to consider the loan as a gift. Even if the borrower insists they’ll pay it back, if the lender considers the money a gift it removes the tension and preserves the relationship. This kind of agreement frequently happens between parents and their children.
• Personal loans: The person could apply for a personal loan from a bank, credit union or other lender. Unlike a credit card, which is a form of revolving credit, a personal loan delivers a one-time payment of cash to borrowers. Then, borrowers pay back that amount plus interest in regular, monthly installments over the lifetime of the loan, known as its term. Some lenders will even offer loans to people with bad credit, but at very high interest rates.
• Buy now, pay later: Sometimes an unexpected expense pops up, say a new laptop that you need immediately for work or school, and while it might not be enough to justify a loan, it’s more than your current emergency fund can handle. Many large retailers and online retailers will allow you to purchase an item on a payment plan. So you’ll pay 25% of the full price and they will ship the item to you with the agreement that you’ll make three more payments over a certain time period.
• Cash advance apps: Sometimes called payday advance apps, cash advance apps are linked to your bank account. This service allows you to borrow money before your paycheck arrives with zero interest. The lending institution then withdraws the repayment from your bank account automatically when payday arrives.

FAQs About Loaning Money To Family

Here are some common questions people have when considering loaning money to a family member.

Is it a bad idea to loan money to a family member?

It can be a very generous and helpful act if you decide to loan money to a family member, especially if that person has a low credit rating and can’t qualify for a loan at the bank. But you should not loan out more money than you are prepared to lose, and you should have the amount of the loan and the repayment schedule in writing and signed by both of you. Sometimes relationships among family members can suffer great harm if the borrower cannot or will not pay the money back.

Is it legal to charge interest on a loan to a friend or family member?

While most loans made to family members do not include interest, it’s not uncommon that a person will charge at least as much interest as they would earn on the money if it stayed in their own savings account — typically not much more than 2%. Most states have usury laws that put a top end cap on how much interest one can charge on a private loan.

Can I deduct taxes on the money I lend to family or friends?

You’ll have to check with your tax advisor, but the only chance you’ll be able to write off money loaned to a family member is if you have a written plan for repayment; otherwise, the IRS will categorize the transaction as a gift. Further, you’ll need proof in writing that the borrower cannot pay, in which case you might qualify for a bad debt deduction.

The Bottom Line

Most family loans are from parents to their children. Even if the borrower plans to pay the money back, these agreements are usually informal and the lender considers the loan more as a gift that won’t jeopardize their own finances if they don’t get reimbursed. However, if the family loan is for a significant amount of money and you need to be repaid, it’s best to get the loan agreement in writing and even carry interest.

Whether you’re a lender or borrower, sign up for the Rocket Money^SM app today for tips on saving, budgeting and growing your wealth for the future.