Weigh the pros and cons before you decide to take on a family loan.
But family loans aren’t always so simple, especially if you don’t set clear parameters ahead of time. Be sure to carefully outline the terms and know the tax laws before you lend to — or borrow from — family.
What is a family loan?
A family loan is when you borrow money from your family and pay it back later. Ideally, it benefits both parties: You get an inexpensive loan through an informal process with the opportunity for your family to earn extra money by collecting interest.
Unfortunately, they still come with some potential drawbacks. A big one: If you’re unable to pay back your family — or you think the rates and terms are unfair — you could inadvertently stir up serious drama.
How to ask your family for a loan
Asking your family for money can be a delicate situation. Before getting started, consider how borrowing might affect your existing relationships. If money is a particularly touchy subject in your family, factor that into how you’ll start the conversation.
Consider other options first
Exploring alternatives shows that you’re serious about borrowing and not just looking for an easy handout. It can also provide an idea of what you’re able to qualify for. If you find you’re eligible for more competitive rates and terms than you expected, you might want to go for that option instead.
Start your search for a loan with these common types of lenders:
- Online lenders. These lenders often offer quick turnaround and streamlined applications. But rates can be higher than what you’d find elsewhere.
- Banks. Already have a relationship with a bank? Some offer discounts for members, plus they’ll already have an idea of your personal finances based on your bank account activity.
- Credit unions. Owned by their members, these institutions tend to offer competitive rates and more relaxed eligibility. But they can take a while, and you’ll have to become a member to get a loan.
Make a case for yourself
Once you’ve exhausted non-family options, be clear that you want a loan and not a gift. Go into the conversation with an idea of how much you need to borrow, exactly how you plan to spend it and when you can reasonably pay it back. The more specific, the better.
The idea is to reassure your family that lending to you isn’t a risk. And it might help if you show how lending can also benefit them. Benefits don’t necessarily need to be in terms of profit — some people might even find this insulting. Think about what would appeal most to the person you’re talking to.
Prepare for a no
Just because you’re related to someone doesn’t mean they’re obligated to give you money. When a family member declines a loan, you can damage your relationship by pushing back or demanding a reason. In short, your relative isn’t required to share why they aren’t interested or even have a reason at all. If you get a no, accept it gracefully and reconsider a more traditional route.
Agree on clear terms
After a family member agrees to your loan’s terms, draw up a formal agreement to avoid any future confusion or surprises. You can write up the terms on your own or use a service like LoanWell to help you come up with a legally binding contract.
Be sure to agree on the loan amount, how long you have to pay it back and any interest rate, if your loan has one. And talk about what happens if you’re late or can’t make your payments.
Is a family loan taxable?
It might be. One benefit of signing a legally binding contract is that the IRS considers it a loan. It could prevent you from paying income tax on your loan if it’s $15,000 or more. Otherwise, the IRS considers your loan a gift and will tax you on it.
If you’re thinking about borrowing more than $15,000 — say, you want to buy a house — it could be worth consulting a tax professional and a lawyer. When you get into loans or gifts of that amount, you could end up paying more than you expected come tax season.
Benefits and drawbacks of borrowing from family
Not sure if borrowing from your family is the right choice? Weigh the pros and cons of getting a family loan first.
Benefits
- No credit check. Even if your family wants to know your credit score before you apply, they aren’t able to pull a hard inquiry that can cause your score to drop a few points. But they might want you to check your credit to see how you’ve been doing financially.
- Low or no interest. Depending on your personal situation, family members are likely to agree to a lower interest rate than you’d find at your bank — if they charge interest at all.
- Room to negotiate. Unlike with other types of loans, you have more of a say in the rate and terms you end up with than you might with a traditional lender. But be understanding. It’s still a loan, and you should treat negotiation professionally.
Drawbacks
- Your relationships are at stake. While you might not end up filing for bankruptcy after failing to repay a family member, family loans come with more emotional risk than other types of financing.
- Complicated taxes. The IRS imposes rules on how much families can give one another and what’s considered taxable income. Larger loans could end up more costly and complicated than borrowing from a traditional lender.
- You’re not dealing with experts. Lenders are well aware of the risks involved with lending you money. Your family may not be as informed and could regret getting themselves into the situation.
Decided to use a lender? Compare online loans today
Starting a business with a family loan
Most lenders aren’t willing to work with businesses that haven’t yet opened their doors. A popular alternative for startups are family loans.
Using a family loan to fund a startup works a lot like any other family loan. However, given new businesses are risky, you might want to draw up a business plan before you meet, which tells your family what your business is and where you see it going in the future.
You might also want to consider asking for an equity investment, instead of a loan. While you won’t own 100% of your new business, you also won’t have to repay the funds you borrow.
Should I give a family member a loan?
Whether it’s a good idea to lend to a family member depends on your unique situation. At best, it could be a way to help out someone you love and possibly make a little money on the side.
However, it could impact your own financial future. That’s because as a lender, you’re taking on risk. Before you give out a loan, look at your personal finances to make sure you can easily afford the amount your relative is asking for.
Will you still be able to afford an emergency expense? Are you risking your retirement funds? If yes, you might not want to give that loan. If you’re still not sure, talk with an attorney or tax adviser to learn more about what you’re getting into.
You may also want to consider asking for collateral, especially if you’re helping out with the purchase of a car or house. Requesting a lien on an asset may strain the conversation, but if the worst-case scenario happens, you’ll have backup.
Should I use a lawyer?
Unless you or your borrower understand tax law and the lending process, the likely answer is yes. A lawyer can help you draw up official documents that can be used come tax season to prove you’re lending to family rather than giving a gift, and they can also help determine if both you and your borrower have settled on good terms.
Alternatives to lending to your family
Giving a loan isn’t the only way to help out a family member. If you have strong credit, an alternative is cosigning a loan with your relative.
By cosigning a loan, you help your family member qualify for a stronger rate while potentially helping them build their credit score. But you’re also on the hook for repayments if your relative can’t make them, and taking on extra debt can make it difficult to apply for loans of your own.
For a simpler option, you could simply gift your family member the money they need. You’ll avoid the tension that comes with collecting repayments, and you won’t have to deal with as many complicated tax questions.
Bottom line
Borrowing from your family could be an alternative to a traditional or short-term loan if you don’t have excellent credit or want to start a business. But it could hurt your existing relationships if you’re unable to repay what you borrow.
Before hitting up Mom, Dad or another relative, learn about more financing options and compare lenders in our guide to personal loans.
Frequently asked questions
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I’m an American citizen. If I borrow from a family member, what kind of paperwork do I need to prove to the IRS that have borrowed?
The person I borrow from lives in Europe. Does that change things?
Hi Looper,
Thanks for getting in touch with Finder. I hope all is well with you. :)
The kind of paperwork would depend on what you have agreed upon with your family member. While you can borrow money with just a simple agreement, if your lender wants to make it legally binding, then a contract would be made. If you take this course of action, then you would need to comply with the requirements to create a legal contract.
Now, since you are borrowing from a person who lives in Europe, creating a legal contract can be more complicated since you have to take into consideration the laws that govern loans in both countries. For this reason, I would highly recommend that you speak to a legal consultant to ensure you are complying with the law.
I hope this helps. Should you have further questions, please don’t hesitate to reach us out again.
Have a wonderful day!
Cheers,
Joshua