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How to Lend Money to Family and Friends

Daniel Bortz

When Sarah Lee Marks's friend needed help with a down payment on a house, Marks and her husband loaned her the money. The couple drew up a written agreement, specifying a set calculation for the interest, the payment schedule, a per diem for any late payments, and a time frame for when the loan was to be paid off. The loan was a better deal than what her friend would have gotten from a bank. "This was someone who's more like a family member than a friend, that's how close we are to her," says Marks, an automobile salesperson who lives in Las Vegas. "It was a very important part of her life, and I wanted to help her with it."

Like Marks's friend, many people turn to friends and family over banks when looking for a way to finance a house, buy a car, or fund a business. According to a 2011 report by the National Association of Realtors, 7 percent of home buyers received a loan from a relative or friend to finance their home. And 14 percent of business owners last year reported tapping friends and family for loans to cover their costs, according to the National Small Business Association.

Family and friends will often provide loans at a lower interest rate than banks, and the deal enables borrowers to avoid additional fees tacked on by traditional lenders.

But for these loans to work, people should take steps to ensure the agreements are as businesslike as possible, experts say. Here are ways to broker the deal safely and avoid harming the relationship:

Put everything in writing. You might be tempted to settle for a verbal agreement since it's with someone you're close to, but this leaves too many variables open to chance, says Thomas Fox, community outreach director at Cambridge Credit Counseling. Putting the loan in writing will enable both parties to treat it as a business arrangement. The agreement should spell out the terms, including any interest, what installments the money will be paid in, the penalty for late payments, and what course of action will be taken if the recipient defaults. Consider using a promissory note form from the Internet Legal Research Group, which provides state-specific notes.

You can also have the document notarized, says Gail Cunningham, vice president of membership and public relations at the National Foundation for Credit Counseling. Doing so will give you more legal standing if the borrower defaults, she says.

Communication is key. Good communication should start at the beginning, says Fox. "The lender should say to the borrower at the outset, 'If you run into trouble with paying me, come to me,'" he advises. Setting up weekly or monthly phone conversations to talk about any issues or concerns is a good way to ensure both parties are on the same page.

"Being proactive and transparent is even more important with friends and family, because there's more at risk personally," says Meg Hirshberg, an Inc. magazine columnist and author of For Better or For Work: A Survival Guide for Entrepreneurs and Their Families. "These are people you have Thanksgiving with. These are the people you see at the sidelines of the soccer game. These are the people in your life, and it's very important that those relationships not get imperiled."

Don't loan with too little interest. The IRS requires intra-family loan rates to reflect the current commercial loan market. If your loan requires little or no interest, you may be required to pay taxes, Cunningham says. Follow the IRS guidelines for interest rates to avoid these taxes. As of August, the Applicable Federal Rate, the minimum rate considered acceptable by the IRS, for loans between family members was 0.25 percent for terms less than three years, 0.88 percent for a three- to nine-year loan, and 2.21 percent for more than nine years.

If you're loaning money for someone's mortgage, use NationalFamilyMortgage.com to take advantage of tax benefits, suggests Asheesh Advani, author of Business Loans from Family & Friends: How to Ask, Make It Legal & Make It Work.

Maintain some boundaries. Just because you're lending a friend or family member money doesn't entitle you to micromanage how they use it, nor does it mean you have co-ownership of what they're buying. "The lender should have no expectations," Marks says. "They should not feel like that it entitles them to use the car or visit the house."

Marks adds, "You have to step back and say, 'I'm just the bank.' If you're going to be the bank, keep your opinions to yourself."

Protect other family members. If you're loaning money to one of your children, consider adding a line to the agreement about what would happen if you were to die. Beth Pearson, a director of marketing for a law firm in Pittsburgh, borrowed money from her mother when she wanted to buy a house. The loan stipulated that in the event her mother died before the loan was paid back, Pearson would have to pay the money back to the estate or she'd receive a lower amount of inheritance. "I have four siblings, so our loan agreement was designed to protect them from me getting more than my share of the inheritance if my mother had died," she says. Doing so helps to prevent any bad blood between your children.

Be proactive if the borrower falters. If the borrower can't repay you on time, work with him or her to develop a new repayment plan, advise Jeanne Fleming and Leonard Schwarz, who write Money Manners, a weekly advice column syndicated by King Features, and co-authors of Isn't It Their Turn to Pick Up the Check? "Don't take 'I'm really sorry but I don't have the money,' for an answer--not if you want your money," Fleming says. "Be sympathetic, but firm."

Schwarz adds: "It's important to get the person who owes you the money recommitted to repaying you. Otherwise, it's far too easy for the borrower to feel, initially, that the loan is of no importance, and, as time goes by, that it's been more or less forgiven."

Loaning money to loved ones comes with risk, but you can minimize that risk by taking the right precautions. That's what Marks did, and it enabled her friend to pay off the loan without any major hiccups.

Twitter: @danielbortz

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