5 Best Ways for Making Loans to Family and Friends
Money Girl explains what you show know about giving, lending, or borrowing when it involves family or friends, so you can protect both your finances and your long-term relationships.
Laura Adams, MBA
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5 Best Ways for Making Loans to Family and Friends
Have you ever wondered if you should make loans to family members or friends? Or maybe you’re the one who’s thinking about borrowing money from someone close to you?
In this episode, I’ll cover what you should know about giving, lending, or borrowing between family and friends. You’ll learn 5 of the best ways to make smart transactions that will help protect your finances and, more importantly, your long-term relationships. .
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5 Best Ways for Making Loans to Family and Friends
While it may seem easy to borrow from or loan money to loved ones, it’s important to understand how it can affect both your financial lives. It’s also crucial to note that how the borrower plans to use the money could play a role in how you handle the transaction. I’ll discuss more about that at the end of this article.
Here are the 5 best ways to exchange money between family and friends, and some key pros and cons that both parties should consider:
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Way #1: Make a Gift
If you can afford to make a cash gift to someone who needs help, instead of making a loan, that’s a wonderful solution. But remember that making the cash a gift means that you don’t intend for any amount of it to be repaid, ever.
Additionally, there are tax implications when you make a gift versus a loan. Many people don’t understand the federal gift tax, or even know that it exists. In a nutshell, any time you give something of value with no expectation of value to be received in return, it’s taxable—unless there’s a legal exception. For 2014 and 2015, you can give up to $14,000, to as many people as you like each year, without having to pay a gift tax. So let’s say you want to give $20,000 to someone this year – you’d have to pay gift tax on $6,000, which is the amount that exceeds $14,000.
The gift giver is generally responsible for paying tax, not the recipient. Here are some additional exceptions for when a gift is not taxable:
- Gifts to a spouse who is a U.S. citizen
- Gifts to a political organization
- Medical expenses (including insurance premiums) that you pay for someone directly to the person or institution providing his or her services
- Tuition that you pay for someone directly to his or her school
So making a payment owed by someone else—for something other than tuition or medical expenses—is a gift to him or her, and may be subject to the gift tax. Also note that you cannot deduct the value of a gift from your income tax return—unless it qualifies as a tax-deductible charitable contribution.
See also: Which Charitable Contributions Are Tax Deductible?
There are also implications for your estate taxes that are linked to the gift tax, so if you’re not sure whether tax applies to your situation, read IRS Publication 559: Survivors, Executors, and Administratorsopens PDF file . If you make a taxable gift, it must be filed using Form 709: U.S. Gift (and Generation-Skipping Transfer) Tax Returnopens PDF file .
Way #2: Make a Personal Loan
If you have cash to spare and want to make a loan to someone, there are several considerations. One is that making a no- or low-interest loan that’s $10,000 or more could make you subject to the gift tax, if the rate you charge is less than the going market rate.
Another huge issue is what happens if the borrower can’t or won’t repay you. The key to making a successful loan is to feel confident that the borrower has the ability and willingness to repay you. Likewise, it’s unethical to take a loan from someone that you can’t or don’t intend to repay.
To make sure both parties are clear about payment expectations and terms of a loan, always have a signed and recorded loan document, known as a promissory note. It protects you if you need to sue someone for repayment – but note that going down that path always takes time and money, and will probably ruin your relationship.
To make sure both parties are clear about payment expectations and terms of a loan, always have a signed and recorded loan document, known as a promissory note.
However, the upside to lending is that you could receive a good return on your money, depending on the interest rate and terms you and the borrower agree to. I’ve loaned money to friends for short-term business needs that turned out to be win-win transactions. My friends got the capital they needed quickly, and I earned an interest rate that matched or exceeded what a bank would charge for a similar loan.
Use a site like Rocket Lawyer or LegalZoom to create a loan document that puts the amount, terms, interest rate, and late fees in writing.
See also: 5 Ways to Get a Loan with Bad Credit
From the borrower’s perspective, the main downside to getting a loan from a family member or friend is that you give up the opportunity to build credit. That’s because your payment won’t be reported to the national credit agencies.
Of course, having no or poor credit is a common reason why you might get turned down for a traditional loan, and consider turning to family or friends in the first place.
Way #3: Co-Sign a Credit Account
Another common way to help someone with no or poor credit is to co-sign a joint credit account, such as a personal loan, car loan, or credit card.
Co-signing a credit application means that you and the other borrower assume equal responsibility for the account. Both of your credit histories will be examined, but a good one can outweigha poor one, on balance.
If payments are made on time, it can be a win-win, because both co-signers will build or maintain good credit. However, if payments aren’t made on time, both co-signers are on the hook for the entire debt (not just half of it), even if the other person was the big spender.
Being fully liable for someone else’s debt could ruin your credit if you can’t repay the full amount on time. So never co-sign any type of loan or credit account without understanding that you’re completely responsible if the other person doesn’t hold up their end of the deal – or worse, dies.
Also, be sure to monitor a co-signed account regularly by viewing it online, or getting paper statements in the mail, to make sure that payments are being made on time every month.
See also: Best Tips to Improve Your Credit Score
Way #4: Use a Marketplace Loan
If you want an alternative to direct lendingor co-signing a debt, consider using a marketplace or peer-to-peer (P2P) platform. These lenders evaluate borrowers based on multiple factors, and match them with individual or institutional lenders who can earn above average returns.
I recently spoke to Gregg Shoenberg, Chairman of Peerform, about their lending approval process. He told me they look at a borrower’s credit, but believe that you’re much more than your FICO score. “We also evaluate other factors that create a more comprehensive profile of a prospective borrower,” said Schoenberg. He explained that a thin credit file may not disqualify a potential borrower if he or she has a steady job and no major credit issues.
So before turning to family or friends for money, consider applying to the following P2P lenders for a competitive interest rate and the ability to build credit:
Way #5: Use a Crowdfunding Platform
The final way to loan money or borrow it is to use a crowdfunding platform such as ZimpleMoney. Here’s how it works:
You submit the amount you’d like to borrow, including the interest rate and terms, and offer it to multiple investors, who may include your family and friends. If you’re interested in loaning money to a loved-one without assuming all the risk, this is an innovative option.
ZimpleMoney also manages loans from beginning to end by administering agreements, tracking loan payments, collecting money, and maintaining tax records. Their free version tracks one loan, or you can subscribe to more comprehensive plans for as little as $18 per year.
See also: A Checklist to Measure Your Personal Finance Success
Final Tip: Consider the “How”
I mentioned that how the borrower plans to use money should play a role in how the transaction is handled. This is because when funds are used to buy a home or pay for education, some or all of the interest that the borrower pays may be tax deductible on his or her tax return.
If you borrow money to buy a home, the loan must be secured in order to take advantage of the mortgage interest deduction. To properly set up and manage a home loan with a relative, use a resource like nationalfamilymortgage.com.
If you’re eligible for an education loan tax benefitor the mortgage interest tax deduction and don’t claim it, you’re paying too much to the government.
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About the Author
Laura Adams received an MBA from the University of Florida. She’s an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura’s previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.