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A family loan is when one family member lends money to another. For instance, a person might want to borrow from a relative to help pay for a down payment on a home. But while a loan to a family member has benefits, it also has drawbacks. If you’re considering a family loan agreement, here’s what you need to know.
What Is a Family Loan Agreement?
A family loan agreement is an agreement between two family members for one to lend money to the other. With a family loan, which is sometimes called an intra-family loan, there is no traditional lender involved and no application process. A family loan agreement can serve as a contract or promissory note that stipulates in writing the amount of money being borrowed and the terms for repaying it. A family loan agreement can also include what will happen if the loan isn’t repaid.
Family Loan Example
Here’s how a family loan might work: A 16-year-old borrower wants to buy a used car and needs $10,000 to do so. She doesn’t have a credit score or any kind of debt. A family member agrees to loan her the money. To teach the borrower to be responsible with money, the family member gives her two years to pay off the loan and charges her 2% in interest. With no credit score and a limited income, the borrower would have a difficult time getting a loan elsewhere. Even if she did, securing a loan with just 2% interest would be unlikely.
How Can You Make a Family Loan Agreement?
To put together a family loan agreement, you need to establish the following information:
Standard loan agreements can be found online, but you may want to get the help of a lawyer if the loan is for a large amount and collateral is being used.
Family Loan Interest Rate
Family loans can have much lower interest rates than loans from a formal lender. There can be tax complications depending on the loan amount and the interest rate charged, so it’s important to do some research. For small loans, however, family members can charge whatever they like for a family loan — including no interest whatsoever.
Pros and Cons of Family Loans
Family loans are especially beneficial to the borrower, but they do come with cons as well.
Pros of Family Loans
Cons of Family Loans
Easier approval process
Could damage family dynamics and personal relationships if the loan is not repaid
Family lender may be more understanding during periods of financial hardship
Will not help strengthen the borrower’s credit score and credit history
No origination fees, and may come with no-to-low interest
The two parties should create a legal loan agreement, which requires some homework (and possibly legal advice)
Family Loan Pros
Here are few advantages of a family loan:
Approval
Loans for personal use require borrowers to submit an application and financial documentation and undergo a credit check. Family loans don’t require any of this. A family member either decides to loan a relative money, or not.
Hardship Options
With a family loan, the family member lending the money may be more lenient if the borrower goes through any financial hardship and has trouble making payments. With a loan from a lending institution, there are often fees and other penalties involved if the borrower is unable to make payments. Some lenders may be willing to establish a new payment plan if the borrower can provide documentation that properly illustrates why they have been unable to make payments. However, this isn’t always the case. If you go too long between payments, there may be legal consequences, and the lender may pursue your assets. Recommended: How Much a Baby Costs the First Year
Avoid Risky Loans
If a borrower is unable to get a loan from a formal lender with a reasonable interest rate, it may be because they have low-to-no credit or they lack sufficient collateral to secure the loan (secured loans come with lower interest than unsecured loans). In this case, the borrower could be taken advantage of by a predatory lender who gives them a loan with unfair terms or conditions, or even a loan shark who lends money at an exorbitant and illegal rate of interest.High-risk loans are expensive and can come with a number of financial and other consequences. When you get a loan through a family member, you avoid all of these problems and risks.
Cheaper
Formal lending rates are influenced by the federal funds rate. Banks usually add 3% to the federal funds rate to establish their prime rate, but that’s the best rate a borrower can get and it’s usually only reserved for large corporations. Depending on their credit profile, many individual borrowers receive more points on top of the going prime rate. The size of the increase depends on such factors as:
If all of this sounds complicated, it is. With a family loan, none of these variables apply. The interest rate is whatever the family lender and the family borrower agree to.Plus, the family lender is unlikely to charge any fees, such as a late payment fee. That means a family loan can be cheaper than a traditional loan.
Family Loan Cons
There are also, of course, some drawbacks to turning to family for a loan:
Conflict
Money and family often don’t mix well. If you stop making payments and your family member isn’t as forgiving as you thought, it could put a strain on your relationship with them. Always think twice before borrowing money from a family member. With lenders, it’s business, but with family, it’s personal.
Credit Building
While the disadvantages and advantages of personal loans should always be considered, a major benefit is their impact on your credit score if you consistently make your payments on time. Pay off a personal loan without any problems, and you may see a significant improvement in your credit score. While family loans don’t involve a hard or soft inquiry into your credit, they also won’t help you establish or repair your credit score. If you’re worried about your creditworthiness, you should consider taking steps to improve your credit so you have other financing options in the future.
Taxes
Family loans can present certain tax complications, particularly for the lender. This is especially true if the loan is greater than $10,000 — in which case the IRS sets a minimum interest rate a lender can charge a borrower called the applicable federal rate. If a lender charges less than that, there can be tax implications. Lenders should refer to the IRS’s applicable federal rates guide to avoid unnecessary tax issues. If the family loan is greater than $16,000 and interest-free, the family lender will need to file a gift tax return with the IRS.
Legal Paperwork
If you’ve never written up a legal document like a family loan agreement, trying to do it yourself can be confusing and complicated. If you want to make sure the document is legally binding, you may want to consider hiring a lawyer to review your loan agreement.
Alternatives to a Family Loan
If a family loan isn't exactly what you're looking for, there are a few alternatives:
Personal Loan
There are many types of lenders for personal loans. Some lenders work only with borrowers who have strong credit; others prefer to work with low-credit borrowers. Borrowers with subprime credit scores may be able to find a lending solution through a traditional lender that makes sense for them. While you may pay more in interest with a personal loan through a traditional lender, you won’t be mixing money and family.
Credit Card
Choosing between a personal loan or a credit card is another option to consider. Personal loans often come with lower interest rates. However, credit cards have benefits, too, such as lower monthly payment options, rewards, and travel points. Shop around and you may even be able to qualify for a 0% introductory APR card. This can help you save money on interest. And again, you can avoid potential conflicts with family members.
Cash
An alternative to a family loan is for a family member to instead make a gift of the amount needed. As a gift, there may be less potential for strain on the relationship between family members. And gifts for amounts less than $16,000 do not have to be reported to the IRS.
The Takeaway
Family loans, in which one family member loans money to another, have benefits. These loans don’t require an application, they can be cheaper for the borrower, and they may come with flexible payment terms. They do have drawbacks, however. For instance, family loans won’t help a borrower build or fix a damaged credit score, and they can hurt family relationships if the borrower is late with payments or defaults on the loan.Because family loans can sometimes cause family complications, it may be worth considering other financing options. With Lantern by SoFi, it’s easy to compare personal loan rates to help find your best option — and keep peace in the family.
Frequently Asked Questions
What are family loans?
Is a family loan considered debt?
Do you have to declare a family loan?
Photo credit: iStock/Six_Characters
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About the Author
Lauren Ward
Lauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.
