Six Rules of Lending to Family Members

| March 9, 2016 | 0 Comments

The Bank of Mom and Dad is a popular institution these days, generally offering favorable terms and frequently more sympathetic treatment in the event of a late payment. That said, there need to be ground rules when you are considering supporting a family member with a loan or gift, and some of these rules can affect your tax return and get you in trouble with the IRS if broken (see #3 and #6).

Rule #1: If married, both spouses must agree on the loan and its terms. This means that I can’t go borrowing from my mother without dad’s consent. Divide and conquer is fine for generals and two-year olds, but the division can be fatal to a loving and trusting marriage. Both spouses must agree if money is to be spent supporting a child.

Rule #2: Only lend money you can afford to lose. William Shakespeare probably said it best: “Neither a borrower nor a lender be; for loan oft loses both itself and friend.” If you can’t afford (or tolerate) the loss of the loan, don’t make the loan. Especially if trying to collect a bad loan from a family member will tear apart the family.

Rule #3: Lending money is a business or investment transaction, no matter who you’re lending the money to. Most consumer loans are secured by collateral like a car or a home. These loans are “safer” than unsecured loans like credit cards and thus often carry lower interest rates. You MUST charge interest on a loan, or it isn’t a loan and becomes a gift. Interest on debt tends to sharpen the focus on the debt’s repayment, and is important in make sure everyone understands this is a business arrangement.

Rule #4: Never cosign a loan unless you are an active participant in the business in which you’re investing. While cosigning a loan is one way to help a loved one build their own credit record, it also leaves you on the hook in the event of a default. Can you afford to take on the loan payments, or can you afford to have your own credit wrecked? For most people, the answer is no.

Rule #5: Commercial lenders generally perform due diligence on their borrowers and so should you. You don’t need to go to the extreme steps that mortgage lenders take these days, but you should have some idea what your deadbeat brother will be doing with the money. Is it a sound investment, temporary support, or is he buying a chinchilla farm? The wackier the idea, the higher the interest rate should be, if you even make the loan.

Rule #6: Business transactions require documentation. Always document the terms of your loan with a promissory note and, if possible, an amortization schedule. This includes things like the interest rate, length of the loan, default provisions, collateral, etc. If one of you dies before the loan is paid off, it’s very hard to prove the terms and amounts to other heirs who may not be repaid. And if the loan is part of a real estate transaction (for example, helping with a down-payment), then record the note with the county and file a reconveyance when it’s paid off. All of these things will help to prove that the loan is in fact a loan when it becomes necessary to do so, like in court when you’re trying to get your money back.

Next month, I’ll discuss some of the tax considerations in helping your family members, like declaring that interest payment as income, even if you decide to forgive the interest (a gift).

This column is prepared by Rick Brooks, CFA®, CFP®. Brooks is director and chief investment officer with Blankinship & Foster, LLC, a wealth advisory firm specializing in comprehensive financial planning and investment management. Brooks can be reached at (858) 755-5166, or by email at brooks@bfadvisors.com. Brooks and his family live in Mission Hills.

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