Combining family and money can be tricky, which is why a Greenleaf Trust expert recommends weighing all the factors and everything should be carefully documented in the case of family loans.
Regina Jegar, Vice President and Senior Fiduciary Officer at Greenleaf Trust and Certified Trust and Fiduciary Director, recently spoke to the Business Journal about family loans that can be convenient for the borrower but can have serious financial, personal and tax implications for the lender – and the family – if not handled carefully.
“Family loans really need to be well thought out and (people need to) consider if these loans can affect family relationships,” Jegar said.
According to a recent article by CreditKarma, a family loan, sometimes referred to as an intra-family loan, is a loan between family members, which differs from personal loans from traditional lenders or peer-to-peer lending from private investors as there are no set requirements or repayment schedules for loans from family members. Usually a family loan is considered when the borrower needs but is not eligible for a loan from traditional lenders, or when the interest rates on traditional loans are higher than the borrower can afford.
This does not mean that the family loan is interest-free. The IRS publishes its applicable federal rate (AFR) monthly, which is the minimum interest rate a lender can charge a borrower on loans over $ 10,000. Rates vary depending on the length of the term, with rates for short-term loans being the lowest. If the lender charges a lower interest than the AFR, the lender will have to pay taxes on lost interest.
As tempting as a family loan based on a handshake agreement or a simple contract may seem, Jagar said it is important to document the transaction so that all parties are aware of the interest rates, payment structure, and what happens if the borrower defaults. loan.
“We always recommend that you seek the help of a lawyer for drafting a (promissory note) or drafting loan documents to make sure they meet all of the requirements that the IRS has to approve a loan to be considered a loan,” she said. she.
Jegar said that while a family loan has advantages – usually for the borrower – the disadvantages often outweigh the benefits for the lender and can include family conflict, borrowers becoming too dependent on parents or grandparents and treating them like a bank, and much more.
“Another drawback is inadvertently that your estate planning goals are not being met as you expected due to the fact that the loans are not properly documented. This is probably the problem that I have most often encountered in my experience, ”she said. “When family members provide these loans – mom and dad or grandparents – after five years or two years of the loan, they get a little weaker in reporting payments, and then when the lender makes a decision, the personal representative or Trustee tries to determine how much the outstanding loan amount ”.
She added that lenders should consider the implications for their property if they give a family loan.
“I don’t think there’s enough attention all the time about whether it makes sense at both ends of the deal, because the lender, if they lend their grandchild $ 300,000 to buy a house or some other amount, maybe it’s $ 300,000 that are being removed from the lender’s investment portfolio, so there is potentially no higher interest rate that could be earned on that $ 300,000 or an overall net rate of return that could be used, ”said Jegar. “This means that the creditor is potentially giving up something. And if they rely on … these numbers in the portfolio and that $ 300,000 for cash flow or for their vital needs, it could be a problem. It should make sense on both sides of the transaction, not only for the borrower, but also for the lender, because the lender is giving up something. “
Borrowers also need to understand that family loans will not help them create credit as they are not registered with a banking institution.
Jagar said she always recommends that family members considering a loan to a relative ask them to use traditional funding first and only grant a loan if they are ineligible. Even so, she said, a potential lender must weigh all factors, including family dynamics, the reliability of the borrower, and whether the lender can potentially allow the loan to be reclassified as a gift – or be willing to sue – in the event of a borrower’s default.
“The most important thing is to consider family dynamics and the impact of these arrangements on the family,” she said. “It all sounds great when you talk about it – oh, I can get a very inexpensive loan from Mom and Dad and they can finance it – but when you really get into it, you have all these considerations that should be really well thought out before moving on. “