Family members sometimes loan money to each other. These “related party” loans are given with the best intentions and, most of the time, are repaid timely and without any problems. However, there are many things to think about before lending or borrowing money to or from a family member.

Consider Your Personal Relationship

Related party loans can taint otherwise good relationships. The Lender expects payments to be made on time without being reminded and often feels that the borrower shows little gratitude. If payments are late, or a phone call must be made, tempers can flare. The lender may also expect the borrower to make financial sacrifices while the loan is outstanding. If the borrower takes a long vacation or makes frivolous discretionary purchases, lenders often feel slighted. On the other hand, having to borrow money from a family member can be a source of embarrassment. Most borrowers reduce personal spending while such loans are outstanding, but they typically do not expect to cease all leisure activities. The borrower may become upset if their personal spending choices come under scrutiny, especially when the loan is being repaid on time; this could cause resentment. There may be further implications in a related party loan than you should also consider. For example, a family rift may arise if the loan carries a favorable interest rate and is made to one of many children. Those who do not receive the loan may think the parents are showing favoritism, or that the borrower is taking advantage of the parent.

Additionally, making the loan to one family member may “open the door” to others requesting the same or a similar financial favor. The lender might assume that the borrower has no other options, or that the loan proceeds will be put to “good use.” However, before participating in a related party loan, both the lender and borrower should have a mutual understanding of the intended use of the loan proceeds and of the borrower’s general financial situation. The best way to do that is by signing a Promissory Note.

Establishing a Promissory Note

If you are going to loan money to a family member, get it in writing. The borrower may be offended at the idea of signing a contract (known as a “promissory note”), but it is advisable to insist on having a formal document drawn up. This document protects all parties involved (and extended family) from misunderstandings and miscommunication. It also gives the lender recourse should the borrower become unable or unwilling to repay the loan. Asking for a promissory note from a family member can be awkward. But if you decide that making the loan is the right thing to do, putting the matter in writing is appropriate and customary for the lender. Signing papers also provides an opportunity for the borrower to demonstrate he or she is a good risk. To help smooth out the paper process, you might point to the professionals. You could indicate that your accountant, financial advisor or lawyer (or all of them) absolutely insists on having a promissory note. You could also mention that you will need a formal document if the IRS audits you.

Terms and Conditions

A good promissory note should cover the following matters:

Purpose: The note should set forth the borrower’s intended use of the loan proceeds. If the funds are not used for the intended purpose, the note might permit the lender to demand the note be repaid immediately or increase the interest rate to penalize the borrower. To ensure that the proceeds are used for their intended purpose, consider making the check payable to the third-party vendee, if possible.

For example, if the loan is to help with a child’s education, or assist in making a mortgage payment, the lender should consider making the check directly payable to the educational institution or mortgage bank.

Interest Rate: Remember, when you take money out of your savings or investment account to make the loan you are losing interest income; it is only reasonable that you are compensated for the loss. If you are still inclined to charge a low interest rate, if any, be aware that there are income and gift tax implications (see below).

Again, if the borrower fails to make all the payments timely, the note might require the interest rate be increased as a penalty for the default.

Repayment: Loans may be repaid in equal installments, usually monthly. These installment loans are typically payable over a term of years. Alternatively, the loan may be payable on “demand” of the lender. This means that the lender may require repayment of the entire loan at any time. Demand loans are usually payable in full at a certain fixed date in the future (with interest) if the lender does not otherwise demand full payment earlier.

Make sure that the timing, frequency, and amount of each installment payment (or demand payment) is practical for the borrower and acceptable to the lender. The most common causes of dispute are late payments.The note should have an amortization schedule attached to it that breaks down the amount of interest and principal in each payment. Amortization programs may be used to calculate the amount of each payment.

Confidentiality: In many cases it may be wise for the loan to remain confidential. Confidentiality is a two-way street with both the borrower and lender. Although, while confidentiality may be advisable, someone other than you should know about the loan in case you have an emergency and for when you pass away. Your power of attorney or executor might be apprised of the situation, or you can place your Promissory Note in your LawSafe and share it with the right person(s).

Collateral and Collecting: A promissory note is a mere promise to pay. If the borrower is unable to pay, the lender will have to bring a lawsuit to collect. If the borrower stops paying, he or she probably has serious financial problems and other creditors. If collateral is available, taking an interest in it is a way to ensure payment, and puts the lender in front of other “unsecured” creditors. Certain assets of a borrower are protected from creditors, including lenders. If the borrower is married, the lender should consider having the spouse join the borrower in signing the promissory note so that the parties are “jointly and severally” liable. That means if there is a default, the lender can go after either or both parties, and the borrower cannot use his or her marital status as a shield to protect their assets and avoid repayment.

Maintaining Records: It is never a good idea to give cash for a loan, or for that matter, accept cash for repayment. Even when you have a signed promissory note, you still need a record of the money exchanging hands. Using a personal check is an effective way of maintaining a paper trail. In all cases we recommend that a copy of the check be maintained in the lender and borrower’s file. If you do give or take cash, make certain that you maintain a written receipt that is dated and signed by both parties.

Make sure you keep a record of every payment so that there is never a question of how much has been repaid. Always make a reference in the memo section of the check that it represents a repayment of the loan (since family members sometimes write each other checks for other reasons).

Income Tax Consequences: Family members are typically reluctant to charge each other interest. However, even if interest is not actually charged, for income tax purposes the IRS may treat the lender as having received interest income (“imputed interest”). So, the lender will have to pay income taxes on the imputed interest, even if he or she received no interest or other payments. There are exceptions to the imputed interest rule.

Conclusion

Related party loans have far reaching implications for both the lender and borrower, including impacting their relationship with each other and the rest of their families; thus, having a professional helping you is usually a good idea. Never loan money you cannot afford to lose and always put the terms of the arrangement in writing. Additionally, both parties should keep good records of all payments. The more money involved, the more closely you should consider having detailed terms and conditions in a written and binding promissory note. If the borrower has assets, it may be a good idea for the lender to use the assets as collateral to secure the loan. Finally, do not forget the income tax consequences involving all loans – Uncle Sam may not be as forgiving as a family member.