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Unfortunately, not everyone has access to credit, which is required when applying for a loan. While some consumers have undesirable credit scores, others don't have any credit, so lenders will deny their loan application or charge them a high interest rate. When these potential borrowers need a loan, they may turn to friends and family.
When Should You Lend Money to Family or Friends?
If a family member or friend asks you for a loan, you have to decide whether you’re willing to loan that person the money they’ve requested. However, some people don’t take loans from friends or family members seriously, which hurts everyone involved. When deciding how to loan money to friends and family, there are a few guidelines you can follow. You should consider how the loan will impact you both emotionally and financially. Emotions are an important factor when it comes to lending money to family and friends. Before lending money, here are a few questions to ask yourself:
- Could I be around the borrower if they miss payments on the loan?
- Would the relationship be ruined if the borrower never pays me back?
- How would I deal with the borrower spending money on luxuries like vacations before paying me back in full?
When it comes to financial ability to make the loan, ask yourself the following questions:
- Do I have enough money set aside for emergencies after making the loan?
- Am I on track with my other financial goals like saving for a down payment for a home and retirement?
- Do I have any consumer debt, such as credit cards, that isn’t paid off in full?
- Would my budget be hurting if I don’t receive a loan payment for one month or multiple months?
- Would I still be in a healthy financial position if I never get repaid?
Also consider things from the perspective of the person asking for the loan. Sometimes a small loan is just what the person needs to get back on their feet. If you’re financially able to loan the money and want to help the person out, don't expect the money to be paid back in full. This way you aren’t offended, but if they do pay the loan back, you have some extra money to put toward your goals.
If you’re not able to lend the money, you can show the friend or family member that you empathize with their situation and perhaps suggest alternatives that may work instead. Personal loans and peer-to-peer lending sites—such as LendingClub—may offer exactly what the person needs. While the decision is yours to make, there can be negative feelings involved by turning down a friend or family member for a loan.
How to Lend Money to Family or Friends
There are a few things you can do to help the lending process if you decide to lend money to family or friends. You should make the process of borrowing money feel like a real loan to ensure that you're going to be paid back. You may want to request the following: a credit report to review the borrower’s past credit behavior, their income, expenses, and their repayment plan.
After you’ve made a decision based on the credit report and repayment plan, you’ll want to come up with a written agreement that lays out how the loan will work. While many people skip this step, having a written document can easily settle any disputes when people end up with different stories a few months down the road. Make sure you note the amount borrowed, interest rate, repayment term, monthly payment and any other terms you’d like to include. You can find sample promissory notes online and customize them to your specific situation. For the best chance of enforcing the loan, make sure both parties have the document notarized. If the loan is for a larger amount—such as $10,000 or more—you may want to consider consulting an attorney to write up a promissory note for your specific situation.
The Tax Implications of Lending Money to Family or Friends
As with most financial transactions, consider how your potential loan to a family member or friend can impact your tax situation. Your taxes are less complicated if you charge at least the applicable federal interest rate. The lender simply reports the interest as income on their tax return and the borrower follows IRS guidelines as to whether the interest is tax deductible based on the use of the money.
Your situation is more complicated if you don’t charge interest or you charge a rate less than the federal rate. The IRS will compute imputed interest, which is what the interest would have been if you charged the applicable federal rate. The IRS will report that amount as interest income on the lender’s tax return and then gift that amount of interest to the borrower. If the gift exceeds the annual gift tax exclusion of $15,000 per donee in 2018, the lender will have to use part of their lifetime estate and gift tax exemption which is currently $5.6 million per person in 2018 or pay the gift tax.
You may qualify for an exception to imputed interest in certain situations even if your loan uses an interest rate less than the applicable federal rate. If the loan is for $10,000 or less and the proceeds of the loan aren’t used to buy an income producing asset, you’ll be exempt from the complex imputed interest rules. If the loan is over $10,000, but less than $100,000, there are other exceptions. However, these exceptions are extremely complex so talking to a certified public accountant (CPA) or tax lawyer that understands the rules may be in your best interest.