Shakespeare advised in Hamlet, “Neither a borrower nor a lender be.” 400 years later, a lot of people agree with him. Mixing debt with personal relationships not only damages those relationships but also makes it hard to balance our own accounts.
But is it really that simple? Are there situations in which it is wise to give a friend or family member an informal loan?
Pros and Cons of Informal Loans
If you are the person asking a relative for money, you probably already know all the reasons in favor of this course of action. Banks often have strict requirements. If your credit score is very poor or you can’t verify your income, you won’t be able to get a loan. Banks also tend to be very strict about repayment terms. If you hit a rough patch and need to skip a few payments, that’s going to show up on your credit score and make it even harder to get other loans in the future!
Of course, there are some disadvantages. For example, your credit score won’t suffer from late payments, but it won’t get better either. The flexibility of an informal loan can also be a disadvantage. If you have to skip a payment, it can make you feel guilty for putting your relative last or worried that they’re analyzing every purchase you make.
To the one making the loan, the advantages are mostly intangible. If it’s always been your dream to make it big so you can help your family do the same, helping a relative through a tight spot will be inherently rewarding. You can charge interest, but it’s unlikely that this will net you a profit compared to investing the money, and it might cause bad blood between you and the person who borrowed the money.
The obvious disadvantage is that your relative might never pay you back. You probably won’t have any way to recover this debt. Whenever possible, avoid lending money if you can’t afford to lose. Refusing to provide a loan can cause resentment, but if your relative takes your money and runs, your relationship will be damaged and you won’t have any money!
Tax Considerations and Usury Laws
If you are loaning your relative more than $10,000, you need to look into the Applicable Federal Rate (AFR), which the IRS uses to determine a minimum amount of interest that should be charged. If you charge less interest than that, your “loan” is considered a gift for tax purposes. You need to be aware of a whole different area of tax law. In 2023, you can give up to $17,000 to any individual before they have to pay taxes on it.
Obviously you would never want to loan shark your own friends and family, but you also need to be aware of usury laws in your state when charging interest on a loan. The limits at which you will face criminal penalties vary substantially from state to state. Make sure to look into this before you draw up repayment terms for a loan.
How Informal Loans Work
So you’ve considered the pros and cons and decided you still want to go through with an informal loan to your friend. The question becomes: how do you do this? Obviously, just handing over a stack of bills or writing a check is always an option, but it can be helpful for both parties to make things a bit more formal.
To formalize the loan, you will need a promissory note. This can be as simple or as complex as you want, but the basic idea is that it spells out the terms of the loan. This includes how much money is being lent, how and when it will be repaid, and any other factors such as interest rates or collateral. A promissory note must be signed by both parties. In most states, you do not need witnesses or a notary, but this can add an extra layer of legal protection even when it’s not required.
Make sure to factor in any estate planning considerations when formalizing a loan. For example, if you borrow $10,000 from your elderly parent, is that coming out of your portion of the estate or is it separate? What happens if your parent dies before you finish repaying the loan?
Alternatives to Informal Loans
If you can’t or won’t give someone money, that doesn’t mean you can’t help them at all. One of the most popular options is to co-sign a loan. This might sound perfect since you don’t have to risk any money, but it has its own disadvantages. If your relative fails to make payments on time or at all, you’re on the hook for them and have no control over the negative impact on your credit score.
Even if your relative doesn’t default on the loan, it still counts against your credit limits. This could cause trouble for you depending on the size of the loan. For example, if you co-sign a mortgage for your child’s home, a bank will factor that in when it decides whether or not to approve a mortgage for your own home. You don’t want to find yourself showing up on Junior’s doorstep and explaining that you can’t afford to live anywhere else after co-signing their loan!
Another alternative, which has grown in recent years, is finding a peer-to-peer lending site. Many different types of lending websites exist. However, the quality of these offerings is going to vary widely. Make sure you do your due diligence before signing up to lend or borrow money through a peer-to-peer site. If something sounds too good to be true, it probably is.
Even if you can’t offer any money, perhaps there’s another service you can offer to a struggling friend or relative. Do you have more free time? Are you an expert at navigating complicated paperwork? If so, you could help connect them to government resources or charities in your area. Often, help is out there but difficult to access for someone who is already overwhelmed.
Get Objective Advice From a Professional
Managing your finances can be challenging even when you don’t try to mix it with family. Financial advisors exist to provide an objective viewpoint on these issues. Contact us today and we’ll match you with an advisor who’s an expert in whatever you need.
The post Informal Loans to Family and Friends appeared first on Advice Chaser.