If you’re thinking of lending money to a friend or family member, whether it’s to help them save on interest payments for a house, car, college tuition or—like most borrowers from friends and family—to consolidate debt, here are a few measures that could reduce the likelihood of money getting in the way of your relationship.
Set a Rate
It may be a gamble to lend money to someone who might not be qualified to get it from another source, so charging interest for loans to friends and family isn’t unreasonable. In fact, it might even be necessary.
Although you might feel uncomfortable taking money from family or friends, especially when you’re generous enough to be a lender, let’s face it: Your money could be safer in a savings account, and lending without charging interest actually amounts to giving more than just the principal.
And if you’re lending more than $13,000 as of the beginning of this year, your “loan” could be treated, for tax purposes, as a gift subject to a tax that you, the lender, have to pay. To ensure your contribution will not be considered a gift, you’ll have to charge your borrower an interest rate that’s at least the applicable federal rate established by the IRS, which for April ranges from 0.83% to 4.7% depending on the duration of the loan.
And if you really need convincing to consider a loan to a friend a worthy investment, you can propose an interest rate that’s lower than your friend’s other possible sources of credit, but higher than what you’d accrue from a savings account.
“There’s certainly a risk. If they can’t borrow from a traditional source, there’s a higher likelihood for default,” says Gerri Detweiler, a credit advisor at Credit.com and author of Reduce Debt, Reduce Stress. Detweiler says you might want to consider how you’d feel if your friend or family were to default. Would you consider the loan a gift, or would you take them to court?
Virgin Money, a social lending services company (Stock Quote: VMED), recommends that borrowers pay back loans in installments, usually monthly, by setting up a repayment plan. (Besides Virgin Money, there are plenty of other social lending sites out there.)
Plans can be a flat rate to be repaid each month. Or, if your friend or family member’s financial situation is expected to improve over time, you can opt for a graduated repayment schedule in which payments would be small at first and increase over time.
You’ll also want to consider what your policies would be for deferment. If your friend or family member has to stop making payments for a period of time, will you allow them to put off payments until their situation improves, or charge them interest payments until they can resume paying you the full amount each month?
Put It in Writing
“If you think it is ‘uncomfortable’ to insist on a written loan agreement, think about how uncomfortable you will be trying to collect if your borrower falls behind,” says Detweiler. “If you have to, blame it on your spouse, accountant, or someone else who ‘insists you get it in writing.’”
And you don’t need to get an attorney to draft a promissory note for you. You can get a cheap one online. Nolo.com offers them for $20 or less, for example, depending on the type of loan.
You’ll want to spell out your terms, including how much is being borrowed, the interest rate you’ll charge, as well as expectations surrounding repayment, including how and when payments will be made and what will happen when payments are late or need to be deferred.
For full-service friends and family loan management, you can arrange your loan through Virgin Money for between $99 and $699, plus a servicing fee of $9 per payment. Virgin provides loan documentation, loan servicing including electronic funds transfers, credit reporting and other services. You can use it to arrange loans for a car, tuition, debt payoff, or a mortgage, as well as business loans between family, friends and business associates, and loans designed to help families share the cost of college.
“If a borrower is struggling, we can give the borrower and lender suggestions on how to get back on track, such as moving a payment to the end of the schedule, putting the schedule on hold for a period of time, or even forgiving payments if the lender is willing,” says Helen Payne Watt, director of content at Virgin Money.
—For the best rates on loans, bank accounts and credit cards, enter your ZIP code at BankingMyWay.com.