Family Loans: Benefits And Pitfalls Of Borrowing From—Or Lending To—Family (2024)

If you have poor credit or limited credit history, it may be challenging to get a personal, student or business loan. If you have exhausted traditional lending options, it may be worthwhile to turn to family for a loan. But you should know, there are both benefits and potential downsides to family loans.

Although the loan structure for family loans is less formal than a traditional bank loan, you should still make sure there are safeguards in place. There are also potential personal and financial risks for both parties. This can include family strain if the borrower—you or your family member—defaults.

You can help ensure a successful family loan arrangement so long as both lender and borrower accept terms of repayment and have a contract in place.

What Makes a Family Loan Risky?

There are several reasons family loans can be risky. “Family loans are more or less the last resort for people who are in dire need of funds,” says Justin Nabity, a financial expert and founder and CEO of Physician’s Thrive, a financial planning firm based in Omaha, Nebraska. Those who need money can ask for financial assistance from their loved ones, but they ultimately risk their family relationships being strained as a result, he says.

One issue to consider is if a borrower can’t pay the money back in time. This hurts the lender because they don’t have access to those funds. “Family loans will always carry a degree of risk depending on the financial situation of both the lender and the borrower,” Nabity says.

How to Structure a Family Loan

To better safeguard both lender and borrower, put a plan on paper. This way, expectations are set and there is a clear understanding about what the repayment terms are. Answer these questions to make sure everyone understands how the loan is structured:

Do You Create a Contract? If So, How?

Most people who engage in family loans tend to move forward on the honor system. “They simply trust that their loved ones will pay them back in due time, and hence they often opt to move forward without a contract,” Nabity says. However, his advice is “it’s always a good idea to put together a contract, outlining everything that goes with the loan.”

Make sure the contract includes:

• The amount being borrowed
• The repayment schedule, including payment frequency, amounts and a payoff date
• The interest rate that will be charged on the loan (more on that later)
• What happens if the borrower stops making payments
• Whether there’s a penalty for paying off the loan early

For larger loans, don’t use a prefabricated agreement. “Have an attorney provide guidance so it’s a sound agreement between both parties,” Nabity says.

Do You Charge Interest?

This varies from family to family. “Usually, these loans are taken because banks are charging high interest rates, which means the borrower can’t afford bank loans,” Nabity says.

But it’s important not to treat the family loan as a gift. “Consider the loan as what it is: a loan. Talk to the family member and figure out an interest rate that is both affordable to the borrower and fair to the lender,” he says.

The lender needs to take into account their tax strategy and should be aware of the minimum interest rates for family loans set by the IRS. This is called the applicable federal rate (AFR), which the government sets every month. Minimum rates generally only apply to loans larger than $10,000. If you’re lending $10,000 or less, you aren’t required to charge interest for tax purposes.

If the loan is larger, the AFR is incredibly low right now. In October 2020, rates ranged from 0.14% for loans of three years or less to 1.14% for loans of more than nine years.

How Do You Set a Repayment Schedule?

When setting the repayment schedule, it’s important to look at the needs of the borrower. Because this isn’t a fixed bank loan with a strict repayment plan, there is flexibility.

“This is a family loan. It doesn’t hurt to be slightly more flexible with the loan repayment plan,” Nabity says. Talk to the borrower, see what their situation is and talk about the term of the loan and the number of payments to be paid—then outline it in the contract.

How Should You Outline Default Options?

It’s important to make clear to the borrower that the money being lent is a loan and that it needs to be repaid. There are a few options to consider if the borrower defaults, but they are limited, says Nabity.

The lender can outline the legal options in the event of a default. “However, in this situation, it is important to know beforehand if the lender is willing to sue a member of their family or simply absorb the financial loss and move on,” he says.

To avoid defaulting, ensure the borrower has a reliable source of income. Is the loan for a business opportunity, a student loan or a car that provides transportation to a job? All of these things should be considered before lending money to family.

Advantages of Family Loans

Yes, family loans carry risks, particularly for the lender, but they also can prove beneficial for both parties. Here are some advantages a family loan carries:

• Poor credit may not be an issue. The lending criteria for family loans are quite different than for other types of loans. Family members don’t generally rely on your borrowing history before they agree to a loan. If you have poor credit, a family member likely will be more lenient, despite your credit challenges.
• A sense of good-will. Helping a loved one through troubled times can be rewarding, particularly for the lender. The family member can feel a sense of pride helping family by providing financial support.
• Interest rates can be lower. A family member can charge less interest than traditional lenders. This can save the borrower money over the course of a loan. The lending relative has the discretion to choose a lower interest rate.
• Reduced exposure to lending scams. If your relative has poor credit and is in desperate need of money, they may be willing to take greater risk to get a loan. If they borrow from you, with a viable structure in place for paying it back, it will reduce their risk.
• The lender can earn interest. A family member who charges interest will earn a return on the repayment.
• More flexible repayment terms. Because the borrower isn’t getting money from a bank, there is greater flexibility when it comes to the repayment. A family member may be a bit more lenient if the repayment isn’t made on time.

Drawbacks of Family Loans

Family loans also can carry significant risks. Here are some of the problems both lenders and borrowers could encounter:

• Family dynamics. Borrowing money from or lending money to a relative can lead to conflict if the loan isn’t repaid according to the agreed-to terms. Before lending money to family, a lender should consider the implications of not getting the money back.
• There won’t be a boost in your credit rating. Because family loans are a private matter, even if the borrower pays the loan back on schedule and in full, this favorable history won’t be reported to credit bureaus. A family loan is a lost opportunity to build good credit standing.
• It can be hard to recoup your losses. Lenders may not be successful in recovering money if a family member defaults. “Since it’s an informal agreement, it’s difficult to enforce if the lender wants to call in delinquent debt. In many cases, the courts and IRS will view it as a gift rather than a loan,” says Chris Motola, business loans analyst with Merchant Maverick, a product comparison site for small business owners.
• Tax implications can get tricky. When dealing with a family loan, both the lender and borrower have to follow tax laws. Lenders are allowed to charge a fair interest rate, and lenders pay interest on income earned from the loan. If you charge less than market interest rates, the IRS may consider your loan as a gift. If this is the case, the lender could be responsible for gift taxes.

Alternatives to Family Loans

Since family loans can lead to discord and other complications, here are some other financial options to consider:

• Gift the funds. If the prospect of drawing up a contract is complicated and worrisome, and if you are in the financial position to do so, family members can give up to $15,000 per individual or $30,000 for couples, and this will not trigger current gift-tax laws.
• Co-sign a loan at a bank. Ask a family member if they would consider co-signing a loan. The co-signer still is taking a risk, though, because if the borrower is late or defaults, the co-signer is responsible for payment. Otherwise, their credit rating will be impacted.
• Explore Small Business Association (SBA) loans. If you are starting a business, or expanding one, explore loans backed by the SBA, which is focused on helping entrepreneurs and small business owners. An application process is required, but the underwriting requirements vary.
• Invite a family member on a credit line. If you’re uneasy about becoming a co-signer on a loan, consider adding your relative as an authorized user on your credit card. This can not only help boost your authorized user’s credit score, but you can potentially earn rewards on their purchases, too. It’s important to have a discussion before adding a relative to one of your credit cards. Any charges they incur are the primary cardholder’s responsibility.