There is a “right way” to execute a loan agreement with family or friends that protects both sides from harm.
Updated: July 25, 2023 | Bill FayHome > Credit > Loans > Loan Agreements With Family And Friends
Friends, family, and financial institutions may have more in common than you think. According to the Census Bureau’s 2022 Household Pulse Survey, over 25 million consumers had to lean on their support network for financial assistance, up from 19.1 million in 2021.
The most popular reasons for asking family members or friends for a loan are to start a business or purchase a home. According to Chamber of Commerce.org, 16% of businesses are funded by bank loans, while loans from family and friends account for 2%-6% of initial small business funding.
The National Association of Realtors said that 52% of first-time home buyers used money from family, primarily parents or friends, to buy a house.
There are other circumstances for seeking a loan from family or friends, such as buying a car, a computer or something more personal like an engagement ring. It also may be a good place to get a loan if you are unexpectedly unemployed or get hit with a sudden illness.
The main advantage of receiving a loan from a friend or family member is that your “lender” is more likely to be flexible about the amount borrowed and payment arrangements. That means you could borrow 100% of the amount you need at a very low-interest rate – possibly 0% — and get an affordable monthly repayment schedule.
Treat a personal loan issued by a loved one with the same respect and professionalism you would a loan from a bank.
If you plan to borrow money from a bank, credit union, or other lending institution, you must sign a legal contract outlining your obligations to the lender: On-time payments for the duration of the loan agreement. This contract is called a promissory note.
Should it be any different if you borrow money from friends or family? Not really. Even if they’ve known you for years, they still need assurance that you’ll repay them as promised. Knowing them well doesn’t override the obligations and responsibilities of taking on a loan.
It is wise to draw up and sign a loan contract regardless of your relationship with the lender. This protects both parties in case of a disagreement. A loan agreement between two individuals is more simplistic but similar to a standard bank promissory note.
Basic terms for a loan agreement with family or friends should include the following:
One of the most important things to address in a loan contract with a friend or family member is what will happen if you can’t pay. The loan agreement should clearly state the lending party’s recourse in case of non-payment, including:
Like any loan contract, you’re legally on the hook for the debt. If you fail to abide by the terms of the agreement, your lender — in this case, your loved one — can take legal action against you. With the contract as proof, the lending party can sue in small claims court, get a judgment and then pursue collection activities on the loan — such as wage garnishment or property liens — just like other creditors.
If you cannot negotiate more reasonable loan terms privately, a lawyer can either negotiate on your behalf to include part of the balance due in a debt settlement agreement or add it to a debt consolidation loan. Taking action before a judgment is entered in small claims court is vital because the lending party can often pursue your assets, bank accounts, and wages.
Relationships built over years or even decades crumble when conditions of a loan agreement are ignored or broken.
If you fall behind while repaying a family loan, keeping the lines of communication open is crucial. Good communication is the best way to avoid animosity with family and friends who have loaned you money. They want to know how the project or business is doing and whether this loan will be paid off.
Write everything down and ensure both sides understand the details of the agreement. Both sides should be realistic about what to expect.
The lender has the most to lose when there is a loan agreement with family or friends. They not only put their money at risk but also put their reputation and relationship in danger. They could lose it all – money, family, and friendships – if things go wrong, and they stand to gain little more than a few dollars of interest if everything goes right.
Here are a few things, some very stark, to consider before making the loan:
If you have examined all the adverse outcomes of making a family loan and decided to go through with it, here are a few steps that might help produce a positive outcome.
Dealing with the IRS is a critical aspect of loans between family members or friends. Both borrower and lender have responsibilities, though most of them fall on the person lending the money.
The first thing the IRS wants is clear proof that this is a loan and not a gift. That means charging and collecting interest under the IRS rules for the applicable federal rate. As of April 2023, the minimum annual rate was 4.86% for short-term loans; 4.15% for mid-term loans; 4.02% for loans more than nine years.
If the parties involved are not paying and collecting at least that much interest, the IRS could deem the money a “gift” and apply gift taxes, depending on the amount.
The next step is to draw up legal documents for the loan. If the loan is for a home, that includes a deed of trust and recording the loan with the county.
The two sides must sign a promissory note that spells out the interest rate, terms and conditions, length of repayment period, and ability to transfer the loan to another party.
There also should be an amortization table showing the amount of principal and interest paid, and the balance due each month for the lifetime of the loan.
The lender must file IRS form 1098 stating how much interest the borrower paid for each year. The lender also must file IRS form 1099, which states how much interest they received on the loan, and report that amount on their tax return. This is an essential step in the loan process, as there are severe tax consequences if any of these steps are missed.
Family loan agreements come with pros and cons, just like any other type of loan. Your relationship with your loved ones will be a primary factor in determining whether this method is wise. Below we compare the benefits and drawbacks of taking out a family loan.
According to a 2022 CreditCards.com survey, ‘many who lent money to family and friends either lost the money, damaged their relationship, negatively impacted their credit scores and even got into physical altercations with the borrower.’ There are alternative sources of money if you want to avoid the genuine possibility that taking or giving a loan to a family member or friend will result in a negative outcome. Admittedly, tapping into sources for mortgage loans, house renovations, or car loans can be challenging. Still, if you’re looking to start a business, the Small Business Administration is a government agency that serves small businesses. They offer a variety of loan programs, including a General Business Loan that could get you $50,000 to $250,000. The SBA also has a Microloan program that offers up to $50,000 for startups and some nonprofit childcare centers. Online, there are peer-to-peer lending sites like Lending Club and Prosper or crowdfunding sites like Kickstarter and Crowdfunder that may deliver the loan you don’t want to ask Mom and Dad for. If you’re looking for something that will help with a renovation or be a down payment for a home or new car, you could consider borrowing from your 401(k) retirement fund. If you already own a home and have enough equity, doing a home equity loan or home equity line of credit (HELOC) could solve the problem.