Family Loans: How To Borrow From and Lend to Family and Friends

Published on: August 14, 2024

Everyone needs a little financial help from time to time. And while there are several options for borrowing extra funds from banks and lending establishments, they might not always be the right fit. You could get stuck with high interest rates or repayment terms that aren't exactly favorable. So, what if there was a way to borrow from someone you trust and have more say in how the loan is structured?

Many people are turning to family for loans. A family loan allows one family member to be the lender and another to be the borrower. It means you can borrow from someone close to you, such as a friend, sibling, parent, grandparent, or in-law, perhaps. There is no involvement with a bank or other financial institution and the parties involved can set up the loan however it works for them.

There are important things to consider when you're going into a financial agreement with someone close to you. So, keep reading below to find out what you should know before entering into a family loan deal with a family member.

Key Takeaways

A family loan allows you to borrow from someone you trust with customizable terms, including the possibility of no interest and flexible repayment options, unlike traditional loans which have fixed terms and often high interest rates.
Only lend to people you trust and ensure the loan amount is within your means. Always document the agreement in writing to clarify terms and avoid potential disputes.
Family loans can be structured with or without interest but may have tax implications, especially if the loan amount or interest rate meets certain thresholds. Consult resources like the IRS for proper documentation and tax requirements.

What Is a Family Loan?

Let's start at the beginning and talk about what a family loan is and how it's different than a traditional loan.

A family loan is an agreement between two parties where one person allows the other to borrow money from them. As with a traditional loan, there will be an agreed-upon amount and a repayment plan.

Some family loans may have an amount of interest that's a part of the deal. However, not all family loans will include any interest payments.

That's the beauty of a family loan, is the parties involved decide together how to structure the loan. You can decide whether the repayment will be one lump sum or through a series of payments. You can choose to charge interest or go with a principal-only setup. There are no preset rules that have to be followed.

A traditional loan will almost always include an interest rate, a repayment period that is determined by the lender, extra fees, and penalties for late payments. Traditional loans can hurt your credit, also, should you default on them. They're often expensive and have more stringent rules, along with eligibility requirements that must be met to get approval.

When Is the Best Time To Use a Family Loan?

Sometimes it just makes more sense to see about a family loan rather than a traditional bank loan. For instance, young adult children who don't have a credit history won't likely qualify for a traditional loan. If a child is trying to purchase a home or vehicle and needs help with the down payment, this may be grounds for a family loan.

Your credit score may have taken a hit at some point and it may be tough to get approved for a traditional loan with a lending establishment. This is an ideal situation for a family loan conversation. According to Experian, about 20% of the United States population has a poor to fair credit score. That makes it tough to qualify for any loan, especially one that's from a trustworthy establishment.

One other scenario worth mentioning is in the case of an emergency. It's not always easy to get a loan funded quickly. A family loan doesn't require a long application and approval process, thus it could be a better fit for those times when extra cash is needed immediately.

Best Practices for Lending to Friends and Family

One thing to remember is it's important to know how to borrow from and lend to family and friends. It helps to keep communication clear and open about what's expected on both sides and can help you avoid awkward situations later on. You don't want to end up losing the close relationship you and the other party have because of a misunderstanding about the loan.

That being said, here are a few things you can do to make sure you don't run into issues during the family loan period.

Lend Money Only to People You Trust

Here's the thing, most of us have family members we don't necessarily trust or close friends who aren't always the most honest. Be smart about who you decide to lend your money to. If you already know you can't trust this one person, don't offer to lend them money with hopes they will be different because of your generosity in letting them use your funds.

Research shows that people who are not trustworthy have already shown a pattern of being unreliable. So, if you've already seen this with your family member or close friend, do not expect anything different when it comes to paying you back on a family loan.

Limit Loans to What You Can Afford

Do not ever put your own financial health in jeopardy to extend a loan to anyone else. Generally, any amount you can loan will be helpful, so don't give more than what you can afford.

A family loan should help alleviate some stress for the borrower caused by a lack of finances. It should not, however, lead to higher stress for you because you cut yourself too short for your own financial responsibilities.

If the borrower requires more cash than what you can provide, they can always ask another friend or family member for a second loan to make up the difference.

Get It in Writing

Clear communication will make the family loan process much easier to navigate. You can make everything more clear by putting your agreement in writing. It gives you something to refer back to should a disagreement arise between the parties involved.

You should include things like, what the repayment period is, how much the payments will be and when they're due, if there's an interest payment, and anything else that could potentially cause an issue. A written agreement should always serve as the foundation of the family loan.

How To Make a Family Loan Agreement

The loan agreement is highly important. This is what both parties will refer back to should they forget what the loan terms are and resolve any issue that comes up about the deal.

There is some information that should be included in every family loan agreement. Make sure you provide all of the following information:

Repayment information: payment dates, final payoff amount, payment amounts, and final payment date
The entire amount of the loan including repayment penalty fees
The interest rate or amount
Whether the loan can be paid off early and if there's a fee
Consequences of not making payments to lender

We recommend you get the loan agreement notarized so the parties both feel the agreement is taken seriously by the other. The better your family loan agreement is, the better chances you have for coming out of the loan period unmarred by a breakdown in communication.

What to Avoid When Lending to Friends and Family

Now let's talk about what you shouldn't do when you're lending a family member money. Though these may seem like common sense tips, we don't always think the way we should when we want to help someone we're close to.

Don't Lend More Than You Can Afford

This tip reiterates what we said above about the amount of money you can afford to loan to someone else. Think about how much you can live without and still meet your financial obligations. You also don't want to give someone so much of your extra cash that you won't be able to handle an emergency that presents in your own life.

Don't over-extend yourself to help someone else. That will cause unnecessary stress to you and most borrowers, also.

Don't Let Guilt Drive Your Decision

You should never decide to lend money to someone based on guilt. That's how you end up in your own financial trouble. We aren't trying to discourage you from helping your loved ones. We just want you to be smart about it.

Make sure to analyze your finances thoroughly before you decide on what to offer for help. Don't lend more money than you can because you feel bad for someone's situation. Ultimately, acting out of guilt will usually lead to a negative outcome. Stick to an affordable amount of help to offer in terms of a family loan.

Don't Lend Someone Your Credit

A family loan should be only in the form of actual money. Do not allow someone to take out a traditional loan on your credit. If they don't pay on the loan, your credit takes a hit. You may lose a close relationship and your ability to borrow all in one bad decision to lend someone your credit.

If you can't afford to give someone cash to borrow, then you should help them find another way to acquire the funds they need.