Budgeting guru Dave Ramsey is fond of saying that Thanksgiving dinner tastes different when you owe someone at the table money. However, that hasn’t stopped Americans from borrowing cash from their relatives.
More than a third of people have borrowed money from family and friends in the past 12 months, according to a survey by the website Finder. The average loan amount was $3,239, and the survey estimates that Americans owe an estimated $184 billion to family and friends annually.
While family loans aren’t inherently bad, they have the potential to ruin relationships if not paid back. Before you borrow – or loan – money to a family member, be sure you understand and guard against the pitfalls. In some cases, it may be better to pursue a loan from an alternative source, such as a personal loan.
Family Loans Basics
A family loan is just what it sounds like. It is one family member giving a relative money with the understanding that the funds will be paid back.
Unlike a bank loan, there is no formal application process, and the details of how money is paid back – such as on a schedule or with interest – can vary. The specifics will often depend on how much you are borrowing and the person making the loan.
Pros of Borrowing Money from a Relative
Cons of Borrowing Money from a Relative
Who to Ask for a Family Loan
If you are asking for a substantial loan, you need to think carefully about which family member to ask. Here are some guidelines to consider:
Financial Means
First and foremost, you need to select a family member who can comfortably make the loan.
While most families don’t discuss the specifics of their finances with one another, you can generally determine which relatives have adequate money and which are living close to the financial edge.
Relationship
A member of your immediate family, such as a parent, child or sibling, may be more likely to say yes to a loan.
However, keep in mind that you may see this person regularly and having an outstanding loan could make these interactions feel strained. On the other hand, a cousin, aunt or uncle may feel less obligated to loan money, but you may also see them at fewer family gatherings which may be a plus.
Personality
If your brother is a gossip or your aunt tends to bring up your every shortcoming at holiday meals, borrowing money from them may not be wise. Look for a relative who is understanding and can exercise some discretion in not sharing the details of the loan with the rest of the family.
How to Ask for a Family Loan
Asking for a loan, particularly a large sum, isn’t something to be shoehorned between cake and presents at a birthday party. Instead, find a time when you can speak one-on-one with the potential lender, either on the phone or, ideally, in person.
Be prepared to share the following information:
- The purpose and amount of the loan
- When and how you’ll pay it back
- What you’ll do if you can’t make a scheduled payment
Once you have made your loan request, give your family member some time to consider it. If they decline, remain cordial and thank them for their time and consideration.
Creating a Family Loan Agreement
If your family member agrees to make the loan, write a contract with the following terms:
Interest Rate
Keep in mind the IRS has rules regarding how much interest must be charged for loans larger than $10,000. If a family member doesn’t charge that much, they may still have to pay taxes on the amount they should have charged. Speak with a tax professional to ensure you don’t run afoul of the rules.
Repayment Schedule
This should include when payments will start, how much must be paid and the monthly due date.
Payment Method
If your family member would like payments made in a certain way, such as checks, cash, Venmo or PayPal, spell it out in the contract.
Penalties or Fees
These could include pre-payment penalties and late fees. If there are no penalties or fees attached to the loan, be sure to specifically mention that in the contract as well.
Default Provisions
The contract should also include details regarding what happens if you fail to make payments as promised. For instance, if you offered some collateral in exchange for the loan, list it here.
Have both parties sign the agreement and have it notarized. Make sure each person has a copy of the agreement for their records as well.
Don’t Make These Mistakes When Borrowing from a Family Member
While family loans can be convenient, you don’t want money to come between you and a relative. You can minimize the chances of that happening by avoiding these mistakes:
- Not being upfront about your financial situation and why you need the money
- Neglecting to put the loan terms in writing
- Missing payments without good cause
- Failing to notify your relative if you can’t make a payment
- Forgetting to say thank you
You want to treat this loan as you would any other financial transaction. Get the details in writing and ask for a receipt when making a cash payment.
At the same time, recognize that your relative is doing you a favor. You are not entitled to their money so be sure to express your gratitude sincerely.
Why a Personal Loan Might Make More Sense
Every family has different dynamics, and in some cases, it may be better to take out a personal loan rather than a family loan. The following are reasons to go with a personal loan instead of borrowing from a relative.
Removes Emotion from Lending Decision
Perhaps the biggest drawback to a family loan is the emotional aspect. A family member could feel pressured into making the loan and then feel resentful later. Or you could get the loan, be unable to pay it back and feel ashamed as a result.
Getting a personal loan from an institution largely helps eliminate the possibility of these emotional pitfalls.
Avoids Financial Stress on Your Relative
Relatives who want to be helpful may say yes to a loan they really can’t afford. No one wants to be a burden on a family member, but in most cases, there is no way to know whether your request will financially squeeze the person you ask.
Larger Loan Amounts Available
Unless you have very wealthy relatives, you can probably only borrow a modest amount from them.
Applying for a personal loan could allow you to access more money.
Eliminates Tax Issues
As the borrower, you likely won’t have any tax issues related to the loan, but it could cause a tax-time headache for your relative. Not only do they have to claim interest as income, but they need to be sure they are following federal interest rules for larger loans. Getting a personal loan takes taxes out of the equation for your family.
Builds Credit
Payments made on most personal loans are reported to the credit bureaus and can help boost your credit score. That’s an important consideration if you have limited, poor or fair credit.
Other Alternatives to Borrowing Money from a Relative
Maybe you don’t want a family loan or a personal loan. Here are some other ways to get the cash you need:
- Use a credit card, either your own or as an authorized user on someone else’s account.
- Tap into home equity with a home equity loan or line of credit.
- Receive a monetary gift from a relative – requesting a gift might also feel awkward, but if you expect an inheritance, it could make sense to request a portion early.
- Apply for a Buy Now, Pay Later plan that will allow you to spread the cost of a purchase over several payments.
FAQs
How Much Money Can Legally Be Given to a Family Member as a Loan?
There is no limit on how much one family member can loan another, but the IRS has rules regarding the minimum amount of interest that must be charged for loans exceeding $10,000.
Do I Have to Report a Family Loan to the IRS?
Borrowers typically don’t have to tell the IRS about a family loan, but the lender may need to claim interest on their tax return. If the loan is large enough, they may have to claim an interest amount even if the loan is tax-free. Talk to a knowledgeable accountant for more information.
