Pass the Pitfalls of Lending to Family

Giving loans to family members is generally a bad idea, but a new service aims to minimize the mess.
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You've heard the advice every time you travel by plane: "Put on your own oxygen mask before helping the person next to you."

That tenet holds true for money as well as for oxygen.

Should you save someone else's financial life at the expense of your own? Especially when it comes to dealing with adult children, this is a dilemma that seems to be arising more frequently.

For instance, should you borrow money from your retirement plan to pay for college? Should you tap your savings for a down payment on a home for the newlyweds? Should you co-sign your daughter's car loan?

When you lend money to friends and family, you're asking for trouble. And it's not just the financial consequences if the loan is not repaid and turns into a "gift." It's the emotional issues that arise when you watch your relative buy a new car or take a vacation before the loan is paid off.

So whenever I receive an email asking for advice about bailing out a troubled offspring or relative, I immediately take the negative approach. I believe that if a bank won't lend money to your son, daughter, brother or sister, you shouldn't put your own hard-earned dollars on the line.

It's a tough analysis, because lending money to a relative isn't a financial decision; it's an emotional one. And with so many people incapable of simply saying no to a relative in need, I believe you should consider carefully the proper way to handle this kind of transaction.

It's very important to legally define and document the terms, interest rate and repayment schedule. That simple step can help your own finances and taxes -- as well as your peace of mind.

Fortunately, there's now an easy way to get help in structuring and managing a private, personal loan.

A Massachusetts-based online company called

CircleLending offers a solution to people who want to make these private loans, but want to do it the correct way.

CircleLending will do all the documentation for a flat set-up fee ranging from $199 for an unsecured personal loan to $549 for a mortgage made between individuals.

It's worth paying these fees. CircleLending will create the appropriate documents to keep the transaction at arms length for both parties. It will help you determine the appropriate interest rates, and then it will calculate the monthly payments, even determining the amortization of a mortgage loan.

But CircleLending also takes the process a step farther. For a fee of $9 per payment, it will actually collect and process the payments, if they're made through an automatic deduction from your checking account. The borrower receives an email reminder a few days before the debit is made. Then the money is electronically deposited in the lender's account. (Circle doesn't earn money on the funds during the transaction.)

The process is transparent, but private. Circle tracks the interest and principal payments, and securely posts a statement of payments online for both parties to follow. It also sends a year-end statement for tax purposes, which is especially important with a mortgage loan, so the borrower can deduct the interest for taxes.

"Using an independent third party to document and collect the payments takes some of the emotion out of the transaction," says Jim Smith, vice president of marketing for CircleLending. "That's where we really add value, as well as taking the administrative -- and mathematical -- hassle off your hands."

Remember, if your loan to a family member isn't properly documented, it can be deducted as a bad debt if it is not repaid, subject to certain limitations. Or the IRS could characterize the transaction as a "gift," which could ultimately impact your estate tax situation. This year you can gift up to $12,000 to any individual estate (or each parent can give that amount to each child and spouse). But larger gifts have larger consequences, so it pays to document your intent appropriately.

Shakespeare said, "Neither a borrower, nor a lender be." I'd add to that, "Especially when it comes to family." But if you are going to make a family loan, doing it correctly will save a lot of financial and emotional heartache. And that's The Savage Truth.

Terry Savage is an expert on personal finance and also appears as a commentator on national television on issues related to investing and the financial markets. Savage's personal finance column by the Chicago Sun-Times is nationally syndicated, and she released her fourth book, The Savage Number: How Much Money Do You Need? in June 2005. Savage also was the first woman trader on the Chicago Board Options Exchange and is a registered investment adviser for stocks and futures. A Phi Beta Kappa graduate of the University of Michigan, Savage currently serves as a director of the Chicago Mercantile Exchange Corp. She also has served on the boards of the McDonald's and Pennzoil corporations.