The number of Americans who need cash flow they just don't have is quite sobering. According to a bankrate survey, only 39% of Americans have enough savings to cover a $1,000 emergency, despite 34% of households having a major unexpected expense over the course of a year. A solid 12% of folks have to borrow from family or friends.
Mixing money with family or friends can be a recipe for strained relations, mostly expectations are misaligned. With people you know well, resolving matters over a handshake and then working out the details later is quite tempting.
Even if you're working with a close friend or family member, If everything is clear upfront it will probably save you from emotional trauma if things go south.
Understand Your Worst Case Scenario
When giving out a loan, there is always default risk, ie the loan may not be paid back. Banks manage their default risk by making a ton of loans, and if a small percentage of those loans default, they’re still earning enough interest on the other loans to profit overall. *It’s not quite as simple as that, they have other risk management techniques which we won’t go into here.
When making one particularly large loan, that default risk becomes that much more important. Knowing that, I decided on my own that I would lend money I was comfortable losing, because I’d rather lose money then cause a rift in the personal relationship with my sister.
Agree On Terms In Writing
Get a loan agreement template. The template will remind of the terms you need to agree on and serve as a written contract between the borrower and the lender.
First fill out the amount and starting date of the loan, which is when the loan extended (but not when repayment begins). The principal is the amount the borrower received from the lender, and the interest is additional payments that are effectively the cost of the loan.
The terms outline the interest rate that accumulates and within what time frame. For example, an interest rate of 8% annually means over a year, the borrower will have to pay an additional $80 on a $1000 loan. Repayments can be made on a monthly basis or any agreed interval. Most repayments will go first towards paying off any interest.
Usually a late fee is designed, just like on a credit card where late payments result in penalties. The lender can typically ask for the repayment of the entire loan and interest if the borrower doesn't pay on time.
Secure The Loan With Collateral
To make the loan a bit safer for the lender, the borrower can also put up collateral. This essentially means that if the borrower stops paying or violates terms of the agreement, the lender can take that collateral.
The simplest way to think of collateral is to consider a house mortgage. If a lender stops receiving payments on a mortgage, they are eventually entitled to the house.
Decide Who Does The Accounting
Someone will have to keep track of the payments, when they are due, and what amount. Both the lender and borrower should actually check these numbers to make sure they're correct.
With personal loans the urge is often to not keep a clean record, which may backfire if anything goes wrong.
Zero interest loans
It may be tempting to offer interest free personal loans to someone you care about, like a family member. Technically the IRS can penalize the lender for giving a below market interest rate in the following way:
- Count the amount of unpaid interest as part of the annual $15000 gift limit
- Charge taxes on interest, even unpaid
What is a fair market interest rate? The IRS actually provides guidelines known as Applicable Federal Rates. The good news is that in today's low interest rate environment these tend to be fairly low.
Gifting money to family
Annually you are allowed to make gifts of up to $15,000 per year tax free (while not counting against the $11.4 million lifetime exemption). After that the giver must file a gift tax return.
When loans are forgiven, for example if you borrow $5000 from your parents and they decide to not ask for repayment, that's considered a gift. Note that gifts to spouses who are US citizens are tax free.
Offer Other Sources
P2P loans (person to person loans) options have been proliferating since the financial crisis, when credit dried up. That means you can find ways to take out a personal loan through a third party, and potentially keep things “clean” between family and friends.
Platforms like Prosper, Lending Club provide personal loans online with a quick response. The rates may be better than tacking on extra debt to a credit card.
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