The family loan agreement is a specialized legal document that allows relations (either by blood or marriage) to enter into a loan agreement. One family member acts as the creditor and the other family member acts as the borrower. It’s similar to standard loan agreements in that the creditor may ask the borrower to pay interest on the amount borrowed. The interest is calculated based on a compound annual rate and is limited by usury laws in the state the agreement was entered into. Of course, this is up to the lender. Oftentimes, family members will forgo an interest payment because of their relationship.
Keep in mind that the family loan agreement may have different names such as loan agreement form between family members, simple loan agreement between family, family loan agreement document, loan agreement for family members, etc. It’s all the same thing and the document here will serve your purposes.
Practically speaking, the family loan agreement is similar to a conventional loan agreement. They have many elements that are the same such as identifying the parties with their full name and addresses, establishing the amount borrowed, specifying their relationship, etc.
It should also go through the process of being notarized and witnessed by a neutral party. The mistake many people make with family loan agreements is that they don’t follow the necessary formalities and may end up with an unenforceable contract. Avoid this by following the steps laid out below.
Yes, it’s a family member and you may know them in a personal capacity but do you understand their financial situation? Just like when entering into an agreement with someone who isn’t a family member, take the necessary steps to find out more about the agreement.
For example, ask the following questions at the bare minimum:
Why is the loan needed
What other payments are being made regularly
Why aren’t they able to get a personal loan or a standard loan for the amount in question
Is the person honest in their financial dealings
After the basic questions have been answered, you may want to move on to the next step which is getting their credit score and requesting a credit check. Yes, some people may balk at this because you’re supposed to be a family member and trust them. While it is true that they’re family, that doesn’t mean you should blindly trust their ability to pay you back. Try to explain to them that it’s necessary to protect you and them while preserving your relationship.
When you get the credit report, you may see that it’s not up to part with what traditional financial institutions will work with. It’s at this point you’ll need to make a choice. Do you give them the money and trust that they’ll do the right thing, do you reduce the amount you’re willing to offer, or do you refuse entirely? If you lend to someone that won’t be able to pay, it’ll sour the relationship more than a flat-out refusal so keep that in mind.
Conversely, you may want to gift them the money instead (assuming you’re financially buoyant enough). There is a limit to how much you can gift an individual tax-free every year.
After going through the due diligence phase and deciding to lend the money to a family member, it’s time to sit down and discuss all of the terms with the borrower. Because it’s a family member, the burden to ensure they understand all the terms and conditions may fall on you so there’s no confusion down the line.
At the very least, cover:
The total amount borrowed
The interest rate (if applicable)
The payment terms (how often and for how long)
Late fees (if applicable)
Consequences in the event of a default and who bears expenses
After deciding on the terms of the agreement, it’s time to draft it so everyone can review and sign. In essence, you’re taking what you’ve already discussed with the family member and putting it in writing.
Payment terms - The exact day of the month or week that the payment should be made
Interest - details how the interest is compounded and at what rate. Generally, the interest is compounded annually so if the loan is only for six months, that will be taken into consideration.
Penalties - keep in mind that this is a family loan so it doesn’t automatically contain language related to payment penalties. With that being said, you’re free to add them if you choose but family members may find this excessive.
Default - what happens if there is a default and it also lets the borrow know that they’ll be responsible for all fees.
We recommend using our family loan agreement creator which will walk you through the nuances of putting together a legally binding loan agreement by asking a few simple questions.
After drafting the agreement it’s time for the lender and the borrower to sign. Gather all of the documents and call two disinterested witnesses. They cannot be family members of the borrower of the lender. In the case of a dispute, you can be sure that they’re neutral and will represent the facts to the best of their ability. While a notary public isn’t required, it is a good idea to include one to strengthen the legality of the agreement.
After signing, the lender should write a check or do a transfer to the borrower. Avoid giving cash so that there will be a paper trail proving that the money was transferred.
While it’s possible to charge interest on a family loan, it’s frowned upon by many family members because, as a lender, you shouldn’t be trying to gain. Instead, your primary reason for granting the loan is to help out a relative.
While this may be true on the surface, it’s important to take a step back and consider the opportunity cost. A bank has relatively low lending interest rates right now due to market conditions but the stock market has been producing incredible returns.
If the lender was to put their money in the stock market for a year or two, what kind of returns would they have when compared to lending to a family member.
Another thing to take into consideration is the tax liability if the loan is above a certain amount and given interest-free. The government considers it a gift if there’s no interest and above $15,000. At that point, someone will need to pay tax.
Even though the lender may need to charge interest rates to avoid certain liabilities and to establish fairness to themselves, it doesn’t need to be exorbitant. There are state usury laws that limit this but the applicable federal rate can be used as a guideline and one percentage point is charged on top of it.
For example, the applicable federal rate as of this writing is 0.18% for short-term compounding. Adding 1% will give you an interest rate of 1.18%. When taking this approach, it’s fair to the lender and borrower.
The reality is that most borrowers that turn to family members have already exhausted the other avenues available to them. They may have poor credit, a tenuous working situation, not enough collateral, etc. Family loans can help a borrower out of a bad situation but if not repaid, it can burn important bridges.
Another thing to consider is that taking a loan from a family member won’t automatically reflect on your credit report because it’s considered ‘off the books.’ That means it won’t build your credit score even if payments are made regularly and on time.
This can be circumvented to an extent by using a processor that will collect payments on behalf of the creditor and take it a step further by reporting to the prominent credit bureaus. This will allow the borrower to get the best of both worlds - a low-interest loan and building their credit score. Services that can do this for you include:
Each one comes with its own benefits and drawbacks. With a bank loan, it’s easy to understand that it’s a business relationship and no one will carry grudges based on the outcome. With family loans, it’s personal and business so if something unexpected happens, tensions can run high - especially at family events.
It’s up to the borrower and lender to decide if the risks are worth it then enter into formal loan agreements to protect everyone involved.
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