Mixing family and money can be complicated, which is why a Greenleaf Trust expert recommends all factors should be weighed and everything should be documented thoroughly in the case of family loans.
Regina Jaegar, vice president and senior trust relationship officer at Greenleaf Trust and a certified trust and fiduciary officer, recently spoke to the Business Journal about family loans, which may be convenient for the person borrowing but could have grave financial, personal and tax ramifications for the lender — and the family unit — if not handled with care.
“Family loans really should be well thought out, and (people should) consider whether or not these loans might interfere with family relationships,” Jaegar said.
According to a recent CreditKarma article, a family loan, sometimes called an intra-family loan, is a loan between family members that differs from personal loans from traditional lenders or peer-to-peer lending from private investors because there are no set qualifications or repayment schedules for borrowing from family members. Usually, a family loan is considered when the borrower is in need but does not qualify for credit from traditional lenders or when interest rates on traditional loans are higher than the borrower can afford.
That’s not to say a family loan is interest-free. The Internal Revenue Service publishes each month its applicable federal rate (AFR), which is the minimum interest rate a lender can charge a borrower for loans over $10,000. The rates vary by term length, with shorter-term loan rates being lowest. If the lender charges lower interest than the AFR, the lender will have to pay taxes on forgone interest.
Tempting as it may be to conduct a family loan based on a handshake agreement or with a simple contract, Jaegar said it’s important to document the transaction, so all parties are aware of interest rates, payment structure and what happens if the borrower defaults on the loan.
“We always recommend that you seek legal counsel for the drafting of the (promissory) note or the drafting of the lending documents to make sure it meets with all of the requirements that the IRS says that a loan needs to meet in order for it to be considered a loan,” she said.
Jaegar said while there are advantages to a family loan — usually for the borrower — the downsides often outweigh the advantages for the lender and can include family conflict, borrowers becoming too dependent on parents or grandparents and treating them as the bank, and more.
“Another disadvantage is, unintentionally, your estate planning goals not being carried out the way that you intend them to be because the loans are not adequately documented. That’s probably the issue that I’ve seen most frequently in my experience,” she said. “When family members make these loans — Mom and Dad or Grandma and Grandpa do — five years into the loan or two years into the loan, they become a little lax in reporting payments, and then when the lender passes, the personal representative or the trustee is trying to piece together how much is outstanding on the loan.”
She added that lenders need to consider the consequences to their estate if they make a family loan.
“I don’t think enough thought is given all the time to whether or not this makes sense at both ends of the transaction, because the lender, if they’re lending a grandchild $300,000 to purchase a home or whatever that amount might be, that’s $300,000 that’s being removed from the lender’s investment portfolio, so it’s missing potentially a higher rate of interest that could be earned on that $300,000 or overall net rate of return that could be used,” Jaegar said. “So, the lender is potentially giving up something. And if they’re relying on … that performance in the portfolio and that $300,000 for cashflow or to meet their living needs, that could be an issue. It needs to make sense at both ends of the transaction, not just for the borrower, but also for the lender because the lender is giving up something.”
Borrowers also should understand that family loans will not help them build credit, since they aren’t on the books with a banking institution.
Jaegar said she always recommends that family members considering making a loan to a relative should ask them to pursue traditional financing first and only make the loan if they don’t qualify. Even then, she said, the potential lender should weigh all factors, including family dynamics, trustworthiness of the borrower and whether the lender can afford to potentially recategorize the loan as a gift — or be prepared to pursue legal action — in the event of the borrower defaulting.
“The biggest thing is considering the family dynamic and the repercussions of these arrangements on the family,” she said. “It all sounds great when you’re talking about it — oh, I can get a very inexpensive loan from Mom and Dad and they can fund it — but when you really dig into it, you’ve got all these considerations that should be really well thought out before you move forward with it.”