Friends and Family Loans

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    What is a friends and family loan?

    If you need money in a hurry and don’t have a reliable way of getting it, friends and family might be the right place to turn. Everyone sometimes hits hard times and needs some extra help. However, borrowing money from friends and family can change your relationship with those individuals and result in extra stress. The goal of this article is to help you think through this financial decision and determine what you should do.

    Just like it sounds, a friends and family loan is a personal loan type in which the lender is somebody you know and who is able to help you financially. Friends and family loans are very flexible and customizable, since you and your lender are determining the conditions of the loan.

    Loans can be arranged quickly to give you instant access to funds, and you can avoid the fees that a formal lending institution would apply. Even though the loan is more casual than with a bank, it is still helpful to get a written agreement to create clear expectations and avoid any nasty misunderstandings down the line.

    How to borrow from friends and family

    Borrowing from friends and family requires tact and delicacy. You should be conscious of the type of relationship you have with your lender, and how a shifting power dynamic could affect your connection with them in the future. It is important to be respectful of their time and their money by treating the deal with professionalism and striving to uphold your end of the bargain in the same way you would for a traditional bank.

    How to deal with lending money to friends and family

    Being on the giving end of the loan is different from being on the receiving end. You must consider your knowledge of the borrower’s fiscal responsibility. You should also be prepared for the risk of the loan not being paid back, just like a bank takes on risk for any loan it issues. Many people choose to give money as a gift with no repayment expectations to avoid stress.

    There are also ways to support your loved ones financially without directly giving or loaning them money:

    • Co-signing a loan: If they are ineligible for a loan on their own, you could apply alongside them and take out the loan together. Be advised that you are now equally accountable for loan repayment.
    • Serving as a loan guarantor: When you guarantee the borrower’s loan, you are promising to pay the lender back if the borrower fails to make payments. This is a good way to reduce risk for the lender.

    Pros and cons of lending money from family and friends

    A friends and family loan can be exactly what you need to get your finances back on track, but it can also quickly turn into a relationship-altering fiasco if not done properly.

    Advantages of friends and family loans

    Borrowing from friends and family has numerous advantages over traditional loans, and these advantages should not be overlooked.

    • Easy approval: The process is much faster and less bureaucratic. You should still get a contract in place to protect both parties in the future, but it is more straightforward than what a bank would ask for.
    • Low or zero interest: Friends and family are much more likely to charge you low interest, or even give the loan for free, whereas a bank would apply market interest rates and charge various fees.
    • Hardship flexibility: Borrowing from friends and family means your lender is personally sympathetic to your situation and will be understanding of missed or late payments due to your circumstances.
    • Avoid risky loans: Vulnerable people in difficult financial circumstances are often taken advantage of by predatory lending institutions, so a friends and family loan saves you from dealing with those.

    Disadvantages of friends and family loans

    While borrowing from friends and family can be a great lifeline, you should be aware of potential downsides that can leave you wishing that you picked a bank loan instead.

    • Interpersonal conflict: The dynamic of a relationship inevitably shifts when one person owes the other money, and misunderstandings and fallings-out are unfortunately common due to financial stress.
    • Tax implications: An interest-free loan might be classified as a gift for the lender’s year-end taxes, while an interest-bearing loan faces additional scrutiny. The lender may need to report interest as income.
    • No credit building: One of the best ways to build strong credit is to borrow money and then pay it back in full and on time, but this only happens through formal lending institutions, not private loans.

    How to make a friends and family loan agreement

    Getting a written agreement may feel awkward or impersonal, but it is highly useful for both the lender and the borrower to get all information clearly in writing. You may even want to get the contract witnessed and notarized just to minimise the chances of any conflict down the road. Here is what your written agreement should include:

    •  The dollar amount being borrowed and its intended use

    •  Repayment amount & frequency

    •  Total loan term (duration)

    •  Interest rate, if applicable

    •  Rules for early or late repayment

    •  Contingencies if the borrower stops payments (e.g collateral)

    Friends and family loans FAQ

    Can I legally charge interest on a friends and family loan?
    Yes, but you must still adhere to legal guidelines and tax policies. You may want to involve an attorney to make sure you are aligned with state & federal laws, and you should also speak to your accountant regarding potential tax responsibilities.
    Is it true that you should never loan money to friends and family?
    This depends entirely on your relationship with the borrower. Many people have had successful financial transactions with friends and family, and simultaneously, many people have had quarrels and even lawsuits with friends and family over money. It is up to the lender to judge the borrower’s character and make the decision.
    What happens if I default on a friends and family loan?
    Assuming that a contract was made, the lender would have various ways to secure the return of their money, including taking you to court or sending the loan to collections. This can be extremely stressful and some lenders may choose to take the loss instead. You should make every reasonable effort to honour the loan terms that you committed to.
    What are the tax considerations for a friends and family loan?
    Usually, the Australian Tax Office does not impose duties on personal gifts or inheritances. However, if a loan or gift was provided for business purposes, the borrower might be liable to pay tax on certain business-type income. Meanwhile, the lender may have tax liabilities on interest earned from the loan.

    Getting the best fuel-efficient cars: the bottom line

    Borrowing money from your friends and family is an important decision that you should not take lightly. There are many ways in which this loan type is better than a traditional bank loan, but it also carries some drawbacks that you must prepare for.

    The key takeaway is that you must treat your lender with the same seriousness and respect that you give to any other lender, because you are accountable for the money. Now that you have read this article, you will know best whether a friends and family loan is the right move for you.