Mixing family and money can be complicated, which is why an expert from Greenleaf Trust recommends that all factors be weighed and that everything be thoroughly documented in the case of family loans.
Regina Jaegar, Vice President and Senior Trust Relations Officer at Greenleaf Trust and Certified Trustee and Trustee, recently spoke to the Business Journal about family loans, which can be convenient for the borrower but could have serious financial ramifications , personal and fiscal for the lender – and the family unit – if not treated with care.
“Family loans should really be well thought out and (people should) consider whether or not these loans might interfere with family relationships,” Jaegar said.
According to a recent CreditKarma article, a family loan, sometimes referred to as an intra-family loan, is a loan between family members that differs from personal loans from traditional lenders or person-to-person loans from private investors because there is no defined qualifications or repayment schedules for loans contracted with family members. Usually, a family loan is considered when the borrower is in dire need but is not eligible for credit from traditional lenders or when interest rates on traditional loans are higher than the borrower can afford.
This does not mean that a family loan is interest free. The Internal Revenue Service publishes its Federal Applicable Rate (AFR) each month, which is the minimum interest rate a lender can charge a borrower for loans over $ 10,000. Rates vary depending on the length of the term, with shorter term loan rates being the lowest. If the lender charges interest lower than the AFR, the lender will have to pay taxes on the lost interest.
As tempting as it may be to take out a family loan on the basis of a handshake deal or a simple contract, Jaegar said it’s important to document the transaction, so all parties are aware. interest rates, the payment structure and what happens if the borrower does not honor the loan.
“We always recommend that you consult with legal counsel for drafting the (promissory) note or drafting the loan documents to make sure it meets all the requirements that the IRS says a loan must meet for.” that it could be considered a loan, ”she said.
Jaegar said that while there are advantages to a family loan – usually for the borrower – the disadvantages often outweigh the advantages for the lender and can include family disputes, with borrowers becoming too dependent on parents or grandparents and treating them like the bank, and more.
“Another downside is that unintentionally your estate planning goals are not being achieved the way you want them to be because the loans are not sufficiently documented. This is probably the problem that I have seen the most often in my experience, ”she said. “When family members make these loans – mom and dad or grandmother and grandfather do – five years after the start of the loan or two years after the start of the loan, they become a little lax in reporting. payments, then when the lender dies, the personal representative or the trustee tries to replenish the outstanding loan amount.
She added that lenders must consider the impact on their wealth if they make a family loan.
“I don’t think we constantly ask ourselves enough whether this makes sense at both ends of the transaction, because the lender, if he lends a grandchild $ 300,000 to buy a house or whatever it is. amount is $ 300,000 which is withdrawn from the lender’s investment portfolio, so it is potentially missing a higher interest rate that could be earned on that $ 300,000 or the overall net rate of return that could be used Jaegar said. “So the lender is potentially giving up something. And if they are relying on… that portfolio performance and that $ 300,000 for cash or to meet their basic needs, that could be a problem. It has to make sense at both ends of the transaction, not only for the borrower, but also for the lender, because the lender is giving up something.
Borrowers should also understand that family loans will not help them build credit because they are not registered with a banking institution.
Jaegar said she always recommends that family members who are considering a loan to a relative ask them to seek traditional financing first and only make the loan if they are not eligible. Even so, she said, the potential lender would have to weigh all the factors, including family dynamics, borrower reliability, and whether the lender can afford to potentially reclassify the loan as a gift – or be prepared to take legal action – in the event of a defaulting borrower.
“The most important thing is to consider family dynamics and the impact of these arrangements on the family,” she said. “Everything looks good when you talk about it – oh, I can get a really cheap loan from mom and dad and they can fund it – but when you really dig you have all these considerations that should be really well thought out before you go.” forward.