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How to Loan Money to Friends and Family and Get Paid Back

Updated on May 1, 2013
Friends and family may sometimes seem like the only source of financing, but the transactions should be treated with as much care as if they were done with a bank.
Friends and family may sometimes seem like the only source of financing, but the transactions should be treated with as much care as if they were done with a bank. | Source

Lending money to family and friends can pose a risk to both the relationship and the money. Most experts advise against the practice, but some people want to help their friends and family members get the financial help they need. If you are a person who feels that a family member is your only source of funds, or if you feel compelled to help a child or sibling out financially with a loan, there are steps you can take to minimize both the personal and financial risks involved in personal loans.

Make Repayment Expectations Clear

It’s important to be clear about your expectations regarding repayment and interest. Clearly articulate that this is a loan, not a gift, and that it needs to be repaid. Agree up front on when it will be paid back. If you’re helping a brother or sister with a bridge loan for new house, repayment may be tied to the sale of the old house. If the money is to be used as a car loan for a child who doesn’t have a credit rating yet, you might require monthly payments.

Tax Considerations

Loans between family and friends are treated the same way other loans are treated for tax purposes. Interest is taxable to the lender. Interest may be deductible by the borrower, if it is for a student loan, investments, or a home mortgage

While you might consider not charging interest on the loan, to be “kind”, that decision could have income tax ramifications. The IRS could impute interest, which means that they will tax you on the market rate of interest they believe you should have charged, even if you didn’t receive a penny.

If you are a borrower, and don’t repay the loan, the IRS could tax you on the benefit of the loan forgiveness.

Loan Documentation

The terms of the loan should be written down in a loan agreement. The agreement should cover the amount borrowed, any security provided, the interest rate, the amount of the payments, and when payments are due. It’s a good idea to also include a loan amortization schedule, which breaks out the principal and interest by payment. If the loan is to be secured by real estate, there should also be a mortgage note executed and registered with the county’s Register of Deeds.

Consider a Third Party Loan Intermediary Service

There are third party services, such as LendFriend and Virgin Money, that will act as a loan intermediary for a fee. These services will prepare the documents based on your agreed terms and arrange for payments by PayPal or direct debit from a checking account. This can make the repayment process less risky, and also make it less uncomfortable for both parties. The loan and payments will also be reported to a credit bureau, allowing the borrower to establish or repair a credit history.

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