Lending Money to Family & Friends: Basic Rules

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Up to $89 billion each year Americans borrow from friends and family, according to the Federal Reserve Board Survey of Consumer Finances. As the national survey by Fundable states “38% of the small startup businesses are launched with the help of the “family-friends” loans.” Yes, borrowing from friends and family is extremely convenient and popular.

Still, there are basic rules to follow when lending to or borrowing from the loved ones. Keep on reading to know how to stop financial issues from destroying your relationships!

The Golden Rule

Borrowing from family and friends is convenient: often we get the needed amount in full with a low (or even 0%) interest. Unfortunately, it’s harder to find conscientious borrowers among friends. Therefore, this way of borrowing might ruin the relationship. Do you know that money issue is the reason why couples argue and an excuse for 22% of divorces?

In this case, making a loan agreement or a so-called promissory note makes a huge sense. The document states the loan requirements and the borrower’s obligations. If the borrower doesn’t carry out duties, the lender can take measures: charge fees or increase the interest, for instance.

The loan agreement is a working measure for lenders: the borrower might not pay off the debt but he will be punished.

What Should the Right Loan Agreement Contain?

An effective loan agreement should contain:

  • The principle – borrowed amount.
  • Interest rate.
  • Regular payments (installments) – how much and how often to pay.

The next important part of the loan agreement states what will happen if the borrower doesn’t pay:

  1. Increasing the cost of the loan.
  2. Taking collateral.
  3. Changing the loan terms.
  4. Applying to the legal institutions.

If you don’t know how to write a loan agreement, you should find the template on the Internet. Here you will find a couple of the most appropriate loan agreement templates.

What are Measures if the Borrower Defaults?

If the borrower can’t pay off the debt or refuses to pay it, the lender can apply to the legal actions. He can turn with the small claim in court, get a judgment and let the collectors purchase your loan. Collection activities on the loan include wage garnishment, property liens, etc. If you can’t negotiate with your friend or relative, you can ask a lawyer to negotiate about debt settlement agreement or a debt consolidation loan.

Still, it’s better to negotiate with a lender before he decides to write a small claim.

What Should a Lender Do?

If you are a lender, you should weight all dangers and probable outcomes of the situation. If your approach is quite responsible, you should:

  1. Ask your potential borrower for a “plan”. You should understand what the borrower needs money for, how much and how often he will pay and what to do if he defaults.
  2. Ask about the financial situation of the borrower and help him create a new budget that includes monthly payments to you.
  3. Define the possible loan terms that will satisfy both sides.
  4. Complete the document that will contain all the terms written.
  5. Try to discern friendship and financial help. Just because you are a lender, doesn’t mean that you can take part in the business (unless it doesn’t define in terms).
  6. Make sure that the borrower understands that it’s a loan, not a gift.

Actually, you can find out how lenders decide whether to give you a loan or not, so it might be useful to steal a page from their book.

IRS has already defined the term “family loan”. According to its definition, the family loan isn’t a gift. If the loan term is less than 3 years, the interest rate should make up 0.38%. If the loan term is from 3 to 9 years, then the interest rate should be as high as 1.85%. If the loan has no interest, this is considered a gift and contains gift taxes.

Furthermore, you should insist on issuing or providing legal documents. A home loan should go along with the deed of trust and record it with the county. The promissory note is the next important document along with the amortization table where you write a principle and all regular payments. Every borrower should also fill in IRS forms 1098 and 1099 that state the interest rate paid and got and the amount on their tax return.

Unfortunately, the rate of people returning money to family and friends is far from 100%. According to the survey by CNN Money in 2009, 43% of family loans weren’t paid in full.

Therefore, you should always start with looking for such alternatives as a mortgage for purchasing a home or loans from SBA for launching a business. If any of the possible options works, then you can ask your friends and family but don’t forget to make a loan agreement.

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